How Does American Express Make Money?

I wanted to write an article on how Venmo makes money, but that meant I had to explain how a credit card company works!

American Express is interesting in this space primarily because it is not one thing, but three things. It is Visa, it is Capital One, and it is Bank America.

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Visa is a processor. When you use your Visa card, a series of messages are exchanged not simply between Macy’s and your bank, but between:

Macy – Macy’s Bank – Visa – Your Bank

And that’s just to say “Oh yea, we’ll let this dude have that money”.

Then the whole conversation goes again to conclude “cool we agree”.

And a third time round is when the money actually gets sent.

The Banks created Visa in 1958 to facilitate these transactions. American Express created its charge card at the same time. MasterCard happened 8 years later.

Visa and MasterCard take less than half a percent whenever you spend on their cards. About 0.2 cents of every dollar to be more precise.

Capital One are the guys running your account. They issue you with a card, and give you customer service. If you’re lucky, they throw in some freebies. For this privilege they take 2 cents on the dollar.

Awesomeness in a bit of plastic

The bit about credit cards you love though is that you don’t need to have any money to spend on it.

Credit cards are a discreet form of lending. It makes borrowing pre-approved and on demand.

Arguably, credit cards may have marked the end of the capitalist system, splitting the need to work from the desire to buy. Awesome!

The hangover

This is where the bank, or lending, bit of it comes in. Just by spending, you’ve signed a loan agreement, and after about a month you are going to be paying interest on it.

You spend $20,000 on your credit card.

Visa charges the merchants $40. Capital One charges the merchants $400.

The retailers who were lucky enough to tempt you with the latest iPhone, those new pair of heels, and the completely ridiculous gift for your girlfriend, they get $19,560.

Swipe fees

Wal-Mart will tell you that your credit card is charging YOU for this, but personally I don’t think they are. Data from Australia, Europe and the US is that when swipe fees get cut, the retailer keeps it.

For all intents and purposes, the retailer, whether it is Wal-Mart or TopShop is paying for you to borrow $20,000.

But only for a month!

APR = something confusing

Annual Percentage Rate might make sense if you borrowed a single sum of money for a year and paid it back all in one go. You don’t, so it doesn’t make any sense. Let’s just estimate that you will pay around 20% to borrow the $20,000 for a year.

This is the Bank America part – you have just taken out a loan with them and it costs interest.

In this instance it’s $4,000 and it is unpleasant. Because the retailer pays for the first month, it will be less, but we’ll ignore that.

American Express, being all three of these things, earn all three of these lines: the processing, the account management and the lending.

American Express

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Skip this bit if you’re more interested in credit cards than American Express.

Because American Express has a big charge card business, unlike other card companies, it makes more money from the spending than from the lending. About 60% of revenues is on the upfront fee. Most other credit card companies will be around 5-15%

This is attractive, American Express versus Credit Cards, because lending can be risky. When someone loses their job they are going to struggle to pay off the card and then zap, money heaven and a nasty experience for everyone. As an investor, stay away from lenders and credit card companies when people start losing their jobs.

When the economy is terrible but it has stopped getting worse, that’s the best time to buy anything to do with lending.

You may doubt it, but seriously, the banks want you to keep your job as much as you do. It stinks for them and for you.

Recently Amex has been struggling because Costco ditched them from their Costco card. Amex has just sold the remainder of this portfolio to Citigroup.

Summary of how American Express makes money

  1. Merchants pay American Express 1-2% to lend you money for a month.
  2. Amex then charge you roughly the same amount of 1-2% every month you revolve and don’t pay off that balance.
  3. Critical to them making money is minimizing their exposure to people who can’t pay off their bills. Don’t borrow more than you can afford. You won’t like your lender when they’re mad.

Bonus – Five things your credit card company doesn’t want you to know

  1. Your credit card company doesn’t want you to pay off your balance. They make 10x as much money making you a loan for a year.
  2. Credit card companies call people who pay off their balance every month deadbeats. This seems a bit rich given that a deadbeat is someone who can’t pay their bills.
  3. They love it when you spend money abroad. Typically you will be charged 3% by the credit card company and up to 3% by the foreign bank. That’s as much as you would be charged for borrowing that money for 3-4 months.
  4. Many people don’t cash in their reward points. Come on!
  5. If you want to boost your credit score you need to run a balance. The trick is to have an automatic minimum payment set up, and then every month transfer in at least double the minimum payment.

If you’re wondering, I’m a deadbeat. I pay off my credit card balance automatically, and twice a year I claim a voucher to spend at the DIY store. American Express doesn’t make much money from me, but they make plenty from everyone else.

Curious to know why borrowing and lending isn’t about money, its about your life? Here’s my blog post on how banks make money.

Otherwise perhaps how Microsoft is going to make money from LinkedIn is more up your street?

Image source: DaveOnFlickr & Philip Taylor

Yuen Lo

2 Comments

  1. im a deadbeat…not paid credit card interest for a long time….about 20 years!!

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