Americans live in credit card paradise. In a matter of minutes, an 18-year-old with no job, no ID, and no credit history can get access to a thousand real American dollars — all from the comfort of their living room. Applying requires little more than a birthday and social security number.
When it comes to income, banks often rely on the “honor system. ” And decisions are usually made on the spot. And if that same 18-year-old manages to click either the “pay in full” button every 30 days or the “Auto Pay” button just once, in 6 months to a year, he or she will be officially ordained as “prime,” or even “superprime” by the credit score gods.
Now inducted into the wonderful world of credit card rewards, he or she will earn, say, 6% cash back on groceries, 5% on travel, and 4% on restaurants. Simply by using their card (something they’d likely be doing anyway) — a reasonably sophisticated consumer can expect to earn hundreds of dollars a year this way. And did I mention this is non-taxable “income,” and thus 6% is really more like 8 or 9%?
Many cards offer free TSA PreCheck, free Disney+, free travel insurance, free grocery delivery, free Uber rides, free airport lounges, and so. much. more.
And for those willing to spend a few extra hours applying for new cards, they can expect to earn not hundreds but thousands, in the form of “welcome bonuses. ” To call this “generous” would be a massive understatement. Who in their right mind would lend a random, unemployed high school student a thousand dollars over the internet with zero collateral?
You wouldn’t. And you definitely wouldn’t do it for free. But don’t forget the first law of business school: if at first a multi-billion-dollar corporation appears generous — especially if its name is “J.
P. Morgan” — look closer, because someone is surely getting ripped off. Let’s call it the “law of conservation of corporate generosity.
” For every lucky cardholder redeeming free business-class flights to Cancún, there’s another one still paying 20% interest on a car repair from three years ago. A whole cottage industry of personal finance gurus exists almost exclusively to tell you to never, ever, ever use a credit card. And not without reason: they cleverly combine the sky-high interest rates of a payday loan, the dangerous convenience of a mobile app, and the psychological abstraction of casino chips.
Plus, because they offer “revolving” credit, you can keep taking on more debt, month after month, even as you fall behind. This is the dark underbelly of the industry. And given these two extremes — free trips to Mexico for some, crippling debt for others, it’s hard not to assume that one is subsidizing the other; that companies lose money on the first type of customer so they can make it back on the second.
But there’s an issue with this theory. It violates the second law of business school: if at first a multi-billion dollar corporation appears to be losing money, look closer, because, unless it’s VC-funded… it isn’t. Credit card companies might be evil, but don’t sell them short — they definitely aren’t dumb.
Here’s the thing about people who pay 20% interest on a car repair from three years ago: sadly, we know who they are. This is a graph of credit scores from 480 (bad) to 840 (good). This is the amount of interest they pay and this is the amount of fees.
Notice a pattern? Yeah. So do the great minds at Bank of America.
If these customers with high credit scores reliably lost them money, banks wouldn’t be handing them out cards like they were candy. Credit card companies, despite their best efforts to appear otherwise, are not charities for rich people. There’s no reason for them to steal from their poor customers and give to their rich ones when they could just… skip that second part.
Now, make no mistake: banks will gladly — unapologetically! — wait years for their customers to miss a payment and then pounce on the opportunity to charge 20% interest. Clearly, this is a good business!
But it’s not a great one. Frankly, there’s only so much interest they can earn. Profiting off a small subset of your customers is nice.
Profiting off every transaction is even better. And that’s exactly what they do. The biggest myth about credit cards is that you can outsmart Citibank simply by paying your bill on time.
Quite the contrary. The most profitable customer is the one with a perfect credit score, who always pays their balance, and who uses a fancy rewards card with lavish benefits. Here’s why: When you, the customer, buy a banana, your money typically travels through not one, not two, but three intermediaries to get to Walmart, the merchant.
There’s your bank, there’s Walmart’s bank, and there’s the network that lets them “talk” to each other. And for the privilege of passing along a series of numbers over the internet, each of these companies takes a slice of the pie. A healthy slice of the pie.
How healthy, exactly? Well, the fact that not one, not two, but — say it with me — three independent middlemen can become fabulously rich in the process should tell you everything you need to know about how little is left over for Walmart. Here’s another clue: In 2008, Home Depot spent more on these credit card fees — called “interchange” — than on health care for its three hundred thousand employees.
That’s a lot of money. Interchange varies by network, card, merchant, transaction, and even method (typing a credit card number, for instance, is more expensive than swiping it), but it consists of a fixed per-transaction cost plus a percentage of the total. That fixed part, by the way, is why some stores have a 5 or $10 minimum purchase requirement — at small amounts, the per-transaction fee eats up a majority of their profit.
But the percentage is where credit card companies really make their billions. Imagine how insanely rich you could become by taking a tiny cut of nearly every purchase made in America! You and I get 2% cash back on groceries.
Chase gets 2% “cash back” on everyone’s groceries. And gas. And dinner.
And travel. And so on. Now, credit card companies justify these fees by arguing that they drive additional spending.
Using a card is fast, it’s convenient, and you don’t see the money leave your bank account for 30 days. All of these things are undeniably good for merchants. It’s also almost certainly true that consumers spend more, on average, when they know they’re earning points or miles or cash back.
Walmart and Apple and Nike tolerate an additional, say, 1% interchange for rewards cards in the hope that they’ll lead to at least a 1% increase in spending. The question is: at what point do these returns start to diminish? At what point does the cost of interchange grow larger than the additional spending they supposedly induce?
Well, American Express has built its whole business around testing these limits. What it cleverly realized is that most credit card companies are playing the wrong game entirely — competing for merchants by keeping interchange at an acceptable level. Sure, Visa and Mastercard are accepted virtually everywhere.
But the cost of this ubiquity is lower interchange. AmEx, on the other hand, decided to forget about pleasing merchants and focus exclusively on competing for customers. Instead of lowering interchange, it drastically raised it.
By doing so, it could turn around and offer you and me much better rewards. These rewards, in turn, attract much wealthier cardholders. Naturally, wealthier cardholders spend more money.
Finally, more spending means more interchange revenue — completing the circle. More interchange, more rewards, more spending… more interchange, more rewards, more spending. Play this out over the course of decades and you get the American Express Platinum — a card that costs more to use than the average Colombian earns in a month.
And you can bet that the kind of person who pays $695 a year for access to a credit card spends a lot of money and thus generates a boatload of interchange. What AmEx figured out is that you don’t have to be in everyone’s wallet. You only have to be in the 20% of wallets that do 80% of all spending.
But as it moved further and further up-market, raising the bar for the amenities consumers expect, it provoked a rewards arms race. After it began building airport lounges, for example, Chase was forced to do the same, launching the “Sapphire Reserve,” its $550-a-year Platinum competitor. And in the process of taking rewards to their current, lavish extreme, AmEx eroded the credibility of its argument: that these cards earn their keep by inducing additional sales.
Sure, when its cardholders spent, say, six percent more on average, Target could stomach paying, say, 3% more on interchange. But, in 2006, its cardholders spent nearly four hundred percent more than the average Discover cardholder. Clearly, the shiny surface of the Platinum card doesn’t magically cause its holders to spend four hundred percent more at Target.
Instead, this coveted status symbol merely attracts the kind of person who already spends more. Similarly, the Platinum card offers a $300 credit at Equinox, a high-end gym. Target and Home Depot, in other words, indirectly pay for these memberships.
And it takes a wild imagination to see how subsidized trips to the sauna lead anyone to buy more pizzas or power tools. American Express is not really in the business of lending money. In fact, many of its cards aren’t actually “credit cards” at all.
Technically they’re charge cards, since you’re not allowed to carry a balance. Nor is it really in the payment processing business — these days moving money around on the internet is what you might call a “solved problem. ” No, it’s becoming increasingly clear that it’s really in the business of hoarding wealthy Americans.
What it specializes in, its “core competency,” is acquiring and retaining the “right” clientele so it can then charge retailers extortionate interchange fees for access to these big spenders. It’s not adding value — stimulating more purchases — it’s extracting value — acting as a kind of toll booth between Apple and the wallets of doctors and lawyers and bankers. There’s a reason, after all, the Platinum card offers Equinox.
There’s no way Target would pay this much interchange for the kind of customer who goes to Planet Fitness. But it is willing for the kind that frequents a $400/month “luxury health club. ” Now, you might be thinking: don’t merchants simply pass these costs on to you and I?
If Chase charged 2. 1% interchange for its Sapphire Preferred card, you’d expect Target to then charge us a 2. 1% fee at checkout to use it.
And since we’d only earn a maximum 2. 1% cash back, rewards would become a pointless exercise — paying at least a dollar to get a dollar back. Suddenly forced to absorb the cost of our “free” vacations, we’d all settle for basic debit cards instead.
But there are two reasons that doesn’t happen. First, while credit card companies charge merchants different fees for their different cards, they forbid merchants from doing the same to you and I. Sure, merchants can impose credit card surcharges — you’ve seen them before — but they have to be the same for every card.
Nor can they choose to accept one card and not another. Each network — Visa or Discover or AmEx or Mastercard — is all-or-nothing. In practice, this means no one is truly paying the cost of their own rewards.
Some cardholders unknowingly pay into the pot while others withdraw from it. And second, as any small business owner will tell you, there’s nothing in the world that customers hate more than fees. They will gladly, cheerfully pay $10 more for their goods before they’ll pay even one dollar in fees.
And rest assured that if your neighborhood bakery does dare impose a fee, the outrage — the raw indignation — will be squarely directed at its owner, Grandma Debbie, not J. P. Morgan Chase.
Understandably, then, most businesses take the path of least resistance: baking the average cost of interchange into their prices for all customers. What this means is that not only are the middle-class Costco credit card users paying for the vacations of the upper-class Platinum cardholders, but lower-class cash customers are too. In 2010, economists at the Federal Reserve estimated that the average cash household loses $149 a year this way and the average card household receives an incredible $1,133.
And “cash” really does mean “poor. ” Those making less than $25,000 a year do less than 5% of their spending with credit cards, while that number is 66% for those making over two hundred thousand. As Georgetown Law Professor Adam Levitin has pointed out, families on food stamps are effectively supporting the 1%.
In other words, cardholders don’t see the true cost of their rewards, they only see the benefits: their points and miles and “free” vacations. But even if they did, they don’t pay those costs — someone else does. So, the poor do subsidize the rich — just not in the form of interest.
And the house never loses. Remarkably, credit card companies make money on both. Now, merchants, of course, don’t like this.
They get blamed for fees they didn’t set and they lose sales from these higher prices. But only a few — Costco and eBay, for instance — are brave enough to call AmEx’s bluff, refusing to accept its cards and betting that these customers will find another way to pay. And even fewer are bold enough to take the nuclear option — refusing credit cards entirely.
That leaves only one way to stop this tax on the economy and regressive transfer of wealth: regulation. American viewers may be surprised to learn that we alone live in credit card paradise. No other country on earth offers such lavish benefits.
The American Express Gold card, for example, is also available in the Netherlands, but without virtually any of the perks that make it popular in the States, like four points per dollar spent at restaurants and $400 a year in credits. Unsurprisingly, then, many Europeans don’t bother. The average American owns 3.
9 credit cards. France, meanwhile, has just 0. 27 cards per capita.
The reason for this is simple: in 2015, the EU, like many governments, set a maximum interchange rate. And 0. 3% doesn’t leave enough room for free trips to Hawaii.
We know these same rules would work in America because… they do. After the Great Recession, Congress capped interchange for debit cards at nearly zero. As a result, good luck finding a debit card that offers $400 a year in “dining credits.
” The problem, of course, is that this is all very obscure and complicated. When the average American hears the word “interchange,” in typical American fashion, we think of driving. We have no idea that we — or our neighbors — are ultimately paying higher prices.
And that’s by design — Discover is happy to let us think we’re getting one over on it as it rolls around in a giant pile of money. Since only the benefits of credit cards are visible, any politician who wanted to regulate them would be met with confusion and anger: “Why are you trying to take away my precious points? ” They’d also have to contend with the large and growing influence of “points hacking” websites, which earn kickbacks from the very same credit cards they, quote, “recommend.
” Indeed, after a bipartisan group of Senators proposed the Credit Card Competition Act of 2023, sites like “The Points Guy” lobbied against it, using their typical air of neutrality (with small print disclaimers about their conflict of interest) to portray the bill as bad for consumers. This is probably a good time to let you know that… none of the cards mentioned in this video paid to be here. And unlike the sneaky world of credit cards, today’s sponsor, Nebula, has a simple and honest business model: you give us three bucks a month and we give you exclusive, high-budget Originals like Tom Nicholas’ new documentary about the rise of Baby Boomers, Neo’s beautifully produced “Under Exposure” series, and my six-part series about China.
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