Suppose you plan to buy an item costing $ 2500, but you don’t have any cash to make immediate payment. You start searching for some help and find your credit card waiting in your wallet, ready to be swiped, say Bank of America Credit card for example.

Now you pay using the card; get a bill after 30 days with an option to pay after another 20 days. This is a maximum of 50 days interest free loan.That quite surprises you because, the same amount (i.e) $ 2500, when borrowed on personal loan at 10 %, gets you paying an Interest for 50 days, which amounts to

= $ 2500 * 10 % * (50/365) = $ 34.24.

whereas here the bank is giving you a loan without interest when you use the credit card. You are confused a bit as if something's wrong !

Swiping your Credit Card !

Well, Let us understand what exactly happens when you swipe your credit card.

You present your Bank of America credit card, A VISA card to pay your bill, at the place where you shopped the item. The cashier swipes your Bank of America card on a Point of Sales (POS) machine provided by another bank, say American Express. Here American Express bank is called the acquirer bank and the process of the cashier swiping the card on that machine is considered, a request for authorization.

Here American Express bank communicates with the card issuer – Bank of America through VISA Network to check the validity of the card and its available credit limit. After reviewing the authorisation request Bank of America approves / declines the transaction which is communicated back to shopping outlet.

At this point, you sign a receipt called Sales Draft printed by the point of sales machine provided by American Express. This is the obligation on your part to pay the money to Bank of America after the generation of your credit card statement. Data on this receipt can be captured electronically and transmitted.

Who pays the retailer before you pay your credit card bill ?

At the end of day or at the end of some period the shopping outlet chooses:

- To submit the sales draft receipt you signed, to American Express Bank who pays the money to the shopping outlet. The outlet pays American Express a fee called Merchant Discount. This may be somewhere around 6% of the sale value = 6% * $ 2500 = $ 150

- American Express Bank sends the receipt electronically to a Visa data center which in turn sends it to Bank of America.

- Bank of America transfers the money to a settlement bank which in turn transfers the funds to American Express Bank.

- American Express Bank pays Bank of America an Interchange Fee of 4% of the sale value = 4% * 2500 = $ 100

- 20 to 50 days later Bank of America gets the money from you, And you don’t pay the interest!!

Who benefitted from the sale ? you or the retailer ? or both ?

So here the shopping outlet pays more than the interest that you should have paid for the loan that you take. You, as a cardholder have the following benefits

- The Convenience of not having to carry ready cash.

- Availability of credit, free of interest.

However what benefits does the shopping outlet get for paying so much money, instead of accepting a ready cash where they could have saved as much as $ 150.

Its nothing but the impulse purchase that you as a customer make, when you don’t count the money that you are spending. And that obviously makes you buy more, which you would not have otherwise easily done when paying by cash! Its for this same reason that some retail outlets offer cash discounts when you pay by cash.

If you did not have access to credit, you would not have bought the item this time, Or maybe not any time soon either. By accepting cards, the merchant is actually extending you credit at the risk of the issuer of the card, in this case Bank of America. He pays money to the banks to carry that risk.

How do you get "cash back" offers ?

So Bank of America uses this money (the interchange fee) to pay back to you when they announce 4% cash back. They insist that the Sales draft that you sign at the retailer should also be from Bank of America (to be swiped on Bank of America point of sales machine). This means they are saving on the Interchange Fee and also pay you a part of the Merchant Discount that they get (In this case Bank of America pays 4% out of the 6% it earned by way of the Merchant Discount payment and gets to keep the balance 2%).

Also, If you have noticed, Bank of America gives you the cash back in the next credit card statement. This “cash back” money accrues them interest too, when invested for a maximum period of 60 days before passing on a part to you.

Say if Bank of America earns an interest of 6% per annum for the cash they carry, they get $ 2500 * 6% * (60/365) = $ 24.65

That is not huge, but money anyways. And when you consider that almost everyone shops with a credit card these days, it is a substantial amount of money.