Understanding the Financial Sector: Credit Card Companies

It's very important to read the account agreement before you apply for a particular card. Some key questions that you want clear answers to:

Is there an annual fee associated with the card? If so, how much?

What is the minimum balance due policy or calculation?

What are the interest rates charges?

What are the terms of rebates, point plans, mileage plans and other incentives?

Then as a cardholder, carefully read the monthly statement and within the "process note," find out the following:

Are all of the charges are bona fide charges? If not, dispute any unauthorized activity.

What is the actual minimum balance due?

What is the termination date of any incentive plans such as "zero rate" financing?

Can you pay the bill by electronic transfer on the card company's Web site (for no extra cost)?

Issuers and Processors

So how do credit card companies generate profits?

Well, there are really two different types of companies involved in the consumer credit/charge card industry. Each one plays a vital role, but they are all too often mixed together by the media and uniformed investors, when discussing the consumer credit card business.

First, we have the card issuers - the banks and sometimes retailers like Wal-Mart or Target (TGT Quote - Cramer on TGT - Stock Picks) that will "private brand" a card. These companies will issue one of the four major brands of cards - Visa, MasterCard, Discover Card and American Express. These cards may take the form of either a charge, credit or debit card.

With credit cards, the issuers actually pay for the cardholder's purchase (your purchase) and in turn lend the money to the cardholder. Thus, the issuers are taking on the credit risk of the cardholder, betting that the loan will be paid back.

In order to fund the loan made to the cardholder, the issuer uses cash from its deposit base or borrows money in the capital markets . Thus, the issuer is making the spread in interest rates (rate earned from cardholders less rate paid on deposits or borrowings) less processing fees and costs less the costs of delinquencies and charge-offs.

The credit card companies love people who don't pay their full balance on the due date and get charged those exorbitant interest rates on the order of 18% to 21% (and higher).

On the other hand, these companies can't stand people like me who pay their full balances on time, as the companies lose money on my activity because I am essentially getting a free loan and the card company pays for the processing fees and overhead.

Some card companies will also charge annual fees for the use of their card. This is particularly true of charge card companies that do not earn interest by design, unless the cardholder does not pay on time.

Second, we have the processing companies. This is where confusion really reigns. While Visa and MasterCard are brand name cards that are issued by banks and other consumer-focused companies, these two giants are not card issuers. Visa and MasterCard do not take any consumer credit risk. These companies are in the business of processing all card types for the issuers.

Each and every time a cardholder uses a card, the processors earn a percentage of the amount charged, plus a flat transaction fee. Thus, MasterCard's stock has been performing quite well (up around 114% over the last 12 months), despite problems within the broader credit markets. And Visa recently experienced a successful IPO , which was one of the largest to ever take place.

Credit Cards & You: Final Words of Financial Wisdom

1. Avoid high interest charges and pay all credit cars on time. If you don't have the money, don't use a credit card. In those instances rely on a debit card.

2. If you need to use use credit cards, find cards with cash-back bonuses. For example, I use my Exxon Mobil (XOM Quote - Cramer on XOM - Stock Picks) MasterCard at Exxon and Mobil stations, my Hess (HES Quote - Cramer on HES - Stock Picks) card at Hess stations and my Costco (COST Quote - Cramer on COST - Stock Picks) American Express card at Costco stores. I earn several hundred dollars a year by optimizing my card utilization.

3. Don't use credit cards for cash "advances" and simply rip up those "checks" that credit card companies send you.

4. Read and understand all the terms of any card agreement and carefully review each monthly statement.

5. Protect you privacy. Be careful how you use a credit card and to whom you provide your card information to. Only use secure Web sites for online purchases. And never respond to personal information "verification" requests from emails. This is "phishing" and it's a major source of fraud and identity theft.

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