The Hidden Benefit of Credit Card Interchange Fees

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Before credit cards, checks were a common way to buy things. When you buy something with a check, it goes through the Automated Clearing House (ACH) system, which is run by the Federal Reserve. Using this system, transactions are made at par, which means that (in most cases) there is no transaction fee. Credit cards and debit cards are different. With card payments, merchants such Wal-Mart and Target (or any other retailer or service that accepts cards as payment for goods and services), pay a transaction fee to the banks that own the cards. These fees are called interchange fees.

Here’s how the interchange fee system works:

There is a complex series of steps involved with the processing of each card transaction, but for the purpose of simplicity they can be summarized as a four-party system: the cardholder (that’s you); the card-issuing bank (the bank that issued your card); the merchant (retailer); and the merchant’s bank. Let’s follow the steps for a $100 transaction:
  1. The cardholder provides debit or credit card information for the $100 purchase.
  2. The merchant passes this information to the merchant’s bank.
  3. The merchant’s bank processes the payment.
  4. The card-issuing bank obtains $100 from the cardholder’s (debit card or credit card) account.
  5. The card-issuing bank sends $98.50 to the merchant bank and keeps $1.50 as an interchange fee.
  6. The merchant bank adds $98 to the merchant’s account and keeps $.50 as a processing fee.
Card Payment System

Source: : http://kansascityfed.org/Publicat/ECONREV/PDF/1q06pach.pdf

Following this simple example, the total charge to the retailer is $2.00, or 2% of the entire purchase.

Why is this a big deal?

On the banking side, these fees are considered a legitimate cost of doing business. They are providing a service that is crucial for making the card payments system work properly while also covering the cost of fraud protection. This seems to be a fair argument. However, much of the money collected from interchange fees goes directly to the banks’ profits, and some of it is used to buy the stuff people can get with their credit card points.
So if you follow the money more closely, the fees are used to reward (and entice!) the biggest credit card spenders—spending that is good for the banks, but not for consumers.

Interchange Fee Debate: Who's in Charge?

There is also a problem with deciding who gets to choose the fee and what a fair price is. Interchange fees are by far the largest cost of using credit cards. In the United States, these fees were historically set by credit card associations and they averaged about 2% (that’s 2% of everything bought with a card)—the highest interchange fees in the world. This is a huge expense for retailers, especially ones that routinely operate on profits of 1% or 2% sales, such as groceries. More recently, the "Durbin Amendment" in the Dodd–Frank Wall Street Reform and Consumer Protection Act gave the Federal Reserve the power to regulate debit card (but not credit card) interchange fees and allowed merchants to offer discounts for cash payments. The settlement of a lawsuit by merchants has also given them the ability to pass on credit card (but not debit card) interchange fees to their customers.

So, how do these new laws affect you?

For the most part, people barely know about interchange fees because we don't see these fees; merchants haven't been allowed to pass them on. Of course, while you don't explicitly "pay" the fees, you're already paying for them by having to pay higher prices for the stuff you buy. The merchant simply passes the interchange fee for credit transactions to the consumer in the form of higher prices on goods or services. Since the cost of the fees has been embedded into the price of everything that we buy, the regulations slated for lowering debit card fees should theoretically lower retail prices. So far this has not happened. Instead of lowering prices, retailers are simply keeping the money that would have otherwise gone to the banks. If you hate the banks, then this might make you happy, but on average, it won’t affect your pocketbook. However, the lawsuit settlement might affect you, and consumer advocates are worried about it. The concern is that now that merchants have the right to pass this fee on to people using credit cards,  that these fees will ultimately cause people to have to pay more at the register.

This is a silly concern.

For one thing, we are already paying these fees through higher prices. It's simply changing the delivery of these fees from a hidden cost (something we can’t see) to an explicit one (something everyone complains about). Beyond that, having the merchants pass on the credit card fee would actually be good for consumers because presumably many consumers, hurt by the higher fees, would stop using the expensive cards. To take the assumption farther, one could predict that people would switch to the fee-free debit cards or cash and reduce overall credit card usage in the market. Just a good habit to get into anyway, despite the potential credit card fee-hike. Consumers considering the pros and cons of switching to debit cards and cash should consider the fact that when you don't pay for things with credit, you're not going to get stuck in debt—by default! And that helps your credit score and your bank account!

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Author: Andrew Wagner

Andrew holds a Master's in Economics from Kansas State University with a focus on the Technology Sector. He enjoys writing about value investing and thinks learning new investment strategies is more useful than hot stock tips. He considers fundamental analysis to be the key to making great long-term investment decisions. You can follow his SprinkleBit portfolio here.

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