When you pay with your credit card, where does the money come from?

For example, you charge $100 on your Elan Financial Fidelity Visa. Is there some kind of “master account” where millions of dollars lay ready to be used for people’s transactions?

Banker here!

Simplified, all transactions are monetary messages. When I send you an ACH transfer, a mutual agreement is formed by merit of accepting the NACHA file. The agreement goes like this: I will subtract $100 from my general ledger and you will add $100 to yours. Then, the Federal Reserve will clear this transaction so we both balance. Both of us (the institutions) ultimately report to and hold accounts at the Federal Reserve. The transfer occurs there, but even still, it is just numbers in a database. Only a very small percentage of the money supply is physical in any way shape or form. Most money is digital.

Now as for loans, we do not have money laying around to fund your loan 1:1. There is no reserve requirement anymore, meaning we can lend as much as we want without anything to back it up. When we give you a loan, we create the money out of thin air, and it becomes real. The dollars go off to be deposited many times over, and the money supply grows. This is why the federal reserve raises interest rates to reduce inflation. Higher interest rates = less loans = less new money being created.

In the case of a credit card transaction, we create the $100 and send it to the merchant. The money supply grows by $100. You pay us back, and the money supply contracts by (a small percent; it is a function of how many times the money has been deposited and lent after our transaction). The merchant gets their $100, and we scooped $5 in interest from the preexisting money supply and our assets grow.

@Floyd
I just wanted to say this was such a good explanation! You did such a good job of simplifying this info.

@Floyd
Which is why money supply growth is directly related to inflation. When MS drastically increases while goods can’t be generated as fast, inflation occurs.

Kameron said:
@Floyd
Which is why money supply growth is directly related to inflation. When MS drastically increases while goods can’t be generated as fast, inflation occurs.

Not necessarily directly related. Inflation only includes consumer goods and services. Any loans taken out to, for example, buy stocks on margin, fund business expenditures, or buy foreign goods aren’t directly related to inflation because these goods and services aren’t part of inflation’s basket.

There was a lot of money creation between 2008-2015, but also very low inflation for this reason. Most of the created money was spent on stocks and other assets, foreign investments, etc. The full equation is Money Supply * Velocity = Price * Transactions. In this case, money supply increased, but velocity decreased at a greater rate.

@Floyd
Explain the part about $5 interest in more detail, please.

Vero said:
@Floyd
Explain the part about $5 interest in more detail, please.

I just used that amount as an example. But basically what I was trying to express is that we create the $100. It’s backed by your debt to us. When you pay us $100 back, the new money is destroyed (from our perspective), and we charge interest. The $5 (example amount) in interest is paid from the borrower in excess of the amount created. This means by facilitating the transaction we were able to earn $5 of pre-existing money.

Vero said:
@Floyd
Explain the part about $5 interest in more detail, please.

The credit card company charges fees for using the credit card. Usually 1-3% to the merchant, and >20% to the customer for any overdue balances.

@Wilkie
A lot of places are passing their fee on to the customer now too. Especially gas stations where they have two different per gallon prices for credit and cash. I hate getting suckered into a store by the cash price.

@Wilkie
The issuer doesn’t charge interchange fees; the network does. For example, VISA charges the full fee to the acquirer and takes a portion for providing the network and the plastics. The issuer takes a portion for providing the customer (or more accurately, access to the customer’s LOC).

@Floyd
The part about money for a loan coming out of thin air is fascinating.

@Floyd
What if the user never pays the $100?

Drake said:
@Floyd
What if the user never pays the $100?

The bank loses money and pays for it out of their own pocket. Besides the satisfaction of ruining the user’s credit score, they can get the money back through their other products, interest, or interchange fees that they charge merchants when people buy stuff with their cards. This happening is probably accounted for and maybe even covered by some insurance the bank pays for.

@Floyd
This really helped my understanding of loans, interest rates, and the Fed. Something that isn’t clear to me, though, why do transfers between banks take time if it’s pretty much just a change in a database? Shouldn’t it be (almost) instant?

@Oaklan
Security, vetting, and some of these databases are OLD. They run on mainframes (or virtual machine copies of mainframes) in FORTRAN or COBOL.

That means that many of these database synchronizations happen overnight (during off-peak hours). That’s why you sometimes don’t get an accurate balance when you check your accounts at 5am Eastern or get a “account balance temporarily unavailable” message.

For a transfer, it can take one overnight sync to fully process the outbound at your bank, one for the receive at the new bank, sometimes a third for confirmation, and often there’s a hold for anti-money-laundering or security which is why 3-5 business days are quoted.

Newer methods (Zelle/Cash App) are faster, but nominally considered less secure (or they charge a fee for facilitating the transfer). Direct bank-to-bank is still pretty old school.

@Oaklan
There are real-time payment networks, most notably Zelle and, in the future, FedNow. But to answer your question, the lifecycle of a card transaction is something like this:

  1. Terminal sends message to network containing transaction information.

  2. Network assesses and approves/denies transaction.

  3. Network forwards message to issuer payment processor (Fiserv, for example). Processor approved/denies the transaction.

  4. Processor forwards message to issuer core banking system. Core approves/denies the transaction.

  5. For approved transactions, message is sent back to the terminal with an approval, and the transaction completes from a customer perspective.

  6. Backend settlement. This is where the money actually moves. Issuers and acquirers move money through their respective processors and can be delivered through traditional money movement channels. This is where the pending takes place; the rest of the process is real-time.

@Floyd
Why do banks offer sign-up bonuses or pay interest for cash deposits when you bank with them then? I thought the whole idea was so that they could then lend or invest your money, but now that’s no longer the case?

@Payne
When you open an account with a bank, you now have an established relationship. You’re now more likely to use them for other lending products in the future, which are profitable.

As for credit card sign-up bonuses, the VAST MAJORITY of those who sign up for introductory periods of 0% do not pay them off before the intro period is complete. This means while they’re out $300 or whatever initially, in 15 months you’ll be paying them interest charges which will likely exceed their initial $300 investment in acquiring you as a customer.

@PEACE
Just to piggyback, this is the reason rewards programs exist in general and lately the push with fast food like Taco Bell. Loyalty via repeat customer and as an additional bonus for the company, the ability to generate business by pushing a coupon or free item to your phone without spending any advertising dollars for “free” since now they have your attention which leads you more likely to buy something since now you have a manufactured reason to visit. Also why it seems all websites offer you like 10-30% discount if you sign up for your email and phone number.

@Payne
The simple answer is that lending is completely separate from other business activities that do require deposits. For example, your deposits are used to purchase treasuries, stocks/bonds, derivatives/Mortgage Backed Securities, etc.

The reason we pay interest is mostly because we have to. We are essentially middlemen between the Fed and the consumers. The Fed gives us a certain basket of rates for our deposits and loans. When we deposit money, they pay us interest because the Fed wants to incentivize money flowing back to them so that they can destroy it as they see fit, which is one of the other mechanisms that they use to control inflation. So let’s say they give us a deposit rate of 1%, we’re going to offer .5% to the consumer so that we pocket the spread. Similar story with loan rates.