Have you ever wondered, "who pays for my credit card rewards?" or "why do some stores have credit card minimums"? The short answer is interchange.
What is Interchange?
Interchange is a fee the store, or "merchant" pays every time you swipe your card.
Most of the money from the fee the merchant pays goes to your bank, or the “issuing bank,” and a little goes to the merchant’s bank, or the “acquiring bank.” Because interchange fees include a percentage of the transaction plus a flat fee, small purchases can cost merchants a lot of money. For merchants, interchange is like a tax they pay to allow consumers to pay via debit or credit card. The price of interchange varies from card to card, and is set by payment networks like Visa® and MasterCard®.
While the origin of interchange fees are debatable, it’s clear today that interchange is a steady revenue stream for banks. For instance, Simple makes its money through interchange and interest margin. Most banks make money through interchange, interest margin, and bank account fees, such as minimum account balance fees, ATM fees, and overdraft fees. Since interchange fees affect profit margins for merchants and banks, there’s been a huge legal tug-of-war over these cents-for-swipes on both credit cards and debit cards.
Let’s dive into how interchange plays a role in rising bank account fees and rewards program credit cards, and how the latter affects income inequality.
Interchange and credit cards
Interchange fees became considerably more problematic for merchants once banks started coming out with rewards program credit cards. From rewards programs with points to frequent flyer miles, credit card companies began issuing competing rewards program credit cards to consumers, vying to be the most generous bank of all the land. Unfortunately, this “generosity” came at almost-zero expense to the credit card companies themselves, and was funded by merchants through colossal interchange fees on rewards program credit cards. Yep, you read that right: banks offered rewards to consumers and paid for them by raising merchant fees, with no additional benefit for the merchants.
Of course, merchants were not happy these unnecessarily high interchange rates, which in part led to the 2005 class-action lawsuit filed by merchants and trade associations: the Payment Card Interchange Fee and Merchant Discount Antitrust Litigation. While the settlement reduced interchange fees, it also protected credit card companies from similar future lawsuits, and still left credit card companies with power to dictate what they charge to merchants.
Rewards program credit cards and inequality
Rewards program credit cards not only hurt merchants, but they also contribute to income inequality. A 2010 public policy study shows that rewards program credit cards result in a transfer of money from low-income to high-income households with the lowest-income households paying around $21 a year and the highest-income households gaining about $750 a year from rewards credit cards. But how does that transfer actually happen? The more money you make, the more likely you are to gain value from a rewards program credit card, which explains the money transfer direction.
Interchange and debit cards
With the 2010 Dodd-Frank financial reform legislation came the Durbin Amendment, which lowered interchange fees for debit cards swipes from an average of 44 cents to a maximum 21 cents per transaction plus 0.05% of the transaction amount in attempt to make interchange fees by banks, “reasonable and proportional to the actual cost” of a transaction. Because banks had to charge fair amounts for processing transactions on debit cards (what a novel idea), this stream of revenue took a huge hit. To make up for money lost, many banks increased insufficient funds fees, eliminated free services, and decreased debit cards rewards programs in favor of more flexible credit card rewards programs. Since the Durbin Amendment went into effect, it’s debatable whether or not the law did what it was intended to do—help consumers pay less.
If you are asking yourself, “what’s a few cents here and there?”, now you know: interchange has a huge effect on merchants, banks, and even income inequality. Next time a shopkeeper frowns at your rewards program credit card or you see a sign that says “$10 minimum for credit cards,” you’ll know why.
Disclaimer: Hey! Welcome to our disclaimer. Here’s what you need to know to safely consume this blog post: Any outbound links in this post will take you away from Simple.com, to external sites in the wilds of the internet; neither Simple nor The Bancorp Bank, our partner bank, endorses any linked-to websites; and we didn’t pay/barter with/bribe anyone to appear in this post. And as much as we wish we could control the cost of things, any prices in this article are just estimates. Actual prices are up to retailers, manufacturers, and other people who’ve been granted magical powers over digits and dollar signs.