How Visa, MasterCard Earn Cash (and Why You Should Care)

Colorful stack of credit cards and shopping gift cards.  Macro with extremely shallow dof.
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Quick quiz: How much does the average American Visa (V) or MasterCard (MA) holder pay directly in fees to those two credit card behemoths every month?

Technically, nothing. But of course, since neither is a charity, they rake in the cash regardless, and cardholders are affected by that process. Here's how they get their money.

Neither a Borrower nor a Lender Be

Both Visa and MasterCard operate immense payment networks. They are, in every sense of the word, the middlemen. They don't extend credit to a cardholder (in the case of a credit card), and they don't send or receive payments from their own resources. They make money by facilitating transactions made with their products.

This is the big difference between Visa and MasterCard and more exclusive brands such as American Express (AXP) and Discover Financial Services' (DFS) Discover. Those two typically operate as card issuers and creditors at the same time. Most American Express holders borrow money from the company when they swipe its plastic.

With Visa or MasterCard, here's how the process goes. A cardholder pays for a good or service. That transaction is transmitted to the merchant's bank (the "acquirer" in industry parlance), which relays it through Visa or MasterCard's network to the financial institution that issued the purchaser's card (the "issuer"). If the cardholder has sufficient credit for the purchase (with credit cards) or the cardholder has enough money in their account (with debit/gift cards), the issuer authorizes the transaction. The acquirer then makes the final authorization.

Fee for All

Of course, all this back-and-forth generates fees.

  • Merchant discount fee. Depending on the type of Visa or MasterCard used (credit, debit, gift card, etc.), a chunk of the total -- generally 1 percent to 3 percent -- will be deducted from the purchase by the acquirer. The merchant gets the remainder -- the purchase total minus the discount fee. The discount fee is divided among the parties involved behind the scenes. The biggest division is the interchange fee, or the monies collected by the issuer for its part in the transaction. These rates are set by Visa and MasterCard, even though neither company receives them directly.

  • Processor and acquirer fee. The processor provides the technology -- cash register, point-of-sale terminal -- used for the sale. The acquirer takes its cut here. These fees vary but typically are small (measured in tenths of a percentage point).

  • Credit card network fees. Here's where Visa and MasterCard start getting paid. They grab fees from the acquirer and the processor. Since those two participants get a small part of the total transaction, the card giants get an even tinier piece. However, when we're talking about billions of purchases, those slivers really add up. In fiscal 2013, Visa's top line totaled $11.8 billion, a 13 percent year-over-year improvement. Net profit was just under $5 billion, a whopping 132 percent higher than in 2012. MasterCard's 2013 revenue was $8.3 billion, while net came in at $3.1 billion. Both figures were 13 percent higher than in the previous year.

Irate About Interchange

Visa and MasterCard have to set their interchange rates high enough to entice banks to issue their cards. But are they too high?

Last year, in the culmination of a long-running dispute, a $5.7 billion class action settlement was approved between a gaggle of merchants and business trade groups and Visa and MasterCard (plus a host of issuers), over what the former considered to be excessive interchange fees.

Already forced to slice such charges for debit cards by the 2010 Dodd-Frank financial legislation, Visa and MasterCard assented to temporarily reducing fees on credit card transactions, too.

But a bunch of dissenting class members, including Target (TGT) and Walmart (WMT), have backed out of the settlement, choosing to pursue their own courses of action.

Advocates for lower card fees argue that the current structure forces merchants to pass along those costs to consumers. Consumers, in turn, buy less and pay more and contribute to those fat revenue and profit figures for Visa and MasterCard. The National Retail Federation claims that payment card fees cost the average American household $400 per year.

So although we as consumers don't technically put money in the hands of those two giants, we still end up paying them. Considering how many cards we collectively own and how often we use them, that adds up to more than a pretty penny.

Motley Fool contributor Eric Volkman has no position in any stocks mentioned. The Motley Fool recommends American Express, MasterCard and Visa, and owns shares of Discover Financial Services, MasterCard and Visa.

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