Understanding the Framework of Credit Cards
According to WalletHub, 84% of the US adult population owned at least one credit card in 2022. So, the magic question is… What makes this product so popular, and is it right for you? This article takes a deep dive into the framework of credit cards and explains how proper use of this tool can have added benefits.
WHO: Often consumers are lured into credit cards by some enticing sign-up bonus or rewards structure, but seldom are discussions held about how and who pays for these rewards. For starters, banks of all sizes tend to partner with payment processing networks such as Visa and Mastercard to operate their credit card division. Most of the big players in this space tend to be household names i.e., Chase, AMEX, Citi.
Surprisingly, banks tend to view this division as a loss leader respective to their overall business structure. In essence, credit cards are not revenue generators but a way for banks to bring consumers into the door and sell them financial products that do make them money i.e., Mortgages, auto loans, non-interest checking accounts. Banks setup the following payment structures to subsidize the rewards it guarantees to its consumer base:
Interchange fees: This fee is collected when a consumer buys something from a merchant. The merchant then pays a negotiated percentage of every proceed to the payment processor (Visa, Mastercard). The processor then splits this fee with the partnering bank. If you’ve ever seen a “We do not accept credit cards” sign, the merchant likely opposes this fee.
Annual fees: Depending on the type of credit card issued, annual fees are charged once a year for cards that offer premium rewards.
Interest charges and late fees: The most notorious of all, these fees are assessed when a consumer fails to pay the full statement balance after a billing period.
Banks need to generate enough of these fees to avoid out-of-pocket costs. When surveying credit cards, it is vital to select an issuer that is financially strong with a reliable rewards structure.
WHAT: There are three main types of credit cards: Store, Travel, and Lifestyle. Each type of card falls under one of two rewards structures: rotating or flat.
- Store: These cards tend to be branded by a specific store and serves to benefit those that shop there
- Travel: These cards can be specifically branded, cobranded, or issued by a bank that has a network with travel partners
- Lifestyle: These cards have a rewards structure geared around everyday spend such as gas and groceries
Rotating cards tend to earn higher multipliers on specific categories for a limited timeframe. For example, a card may earn 5x cash back on gas for a specific quarter of the year up to a certain spend limit. A flat structure is the easiest to understand with just one earnings rate for every category. Rewards earned may appear as cashback or miles depending on the type of card issued. When assessing credit card offers, the right card should suit your normal everyday spend. For example, a consumer should not opt-in for a premium travel card if they hardly incur travel expenses throughout the year. A credit card should not spur new spending habits but should rather add a layer of security to your normal everyday spend.
WHY: When utilized properly, credit cards can provide some neat perks depending on the type of card issued. Here are some of the benefits:
Extra layer of security: With the rise and sophistication of bad actors in recent time, it can be useful to leverage credit during instances such as disputing a transaction, returning an item, or utilizing a card’s extended warranty.
Insurance protections: Popular amongst top cashback cards, some provide perks such as cellphone protection that can reimburse an owner for a lost or damaged phone. Top travel cards can also provide trip cancellation insurance for flights and primary collision damage coverage to help save on rental car costs.
Tool for building or repairing credit: Maintaining a solid credit score can become vital to achieving some financial goals. Banks can offer secured or student cards to help a consumer build or repair their credit profile.
Secured cards tend to have limits based on the initial deposit made by the consumer and can help them start or repair a credit profile. Student cards can serve as an educational tool for young adults looking to build a credit profile and develop sustainable financial habits.
In summary, understanding the framework of credit cards can help a consumer determine if and how it fits into their financial picture and evaluate how to effectively leverage this financial tool.