How do credit card companies make profit?

1. You are correct. Credit card companies charge the merchant for every transaction. But the merchant isn't necessarily going to give you discount for paying in cash. The idea is that by providing more payment options, they increase sales, covering the cost of the transaction fee. That said, some merchants require a minimum purchase for using a credit card, though this may be against the policies of some issuers in the U.S. (I have no idea about India.)

2. Also correct. They hope that you'll carry a balance so that they can charge you interest on it. Some credit cards are setup to charge as many fees as they possibly can. These are typically those low limit cards that are marketed as "good" ways to build up your credit. Most are basically scams, in the fact that the fees are outrageous.

Update regarding minimum purchases:

Apparently, Visa is allowing minimum purchase requirements in the U.S. of $10 or less. However, it seems that MasterCard still does not allow them, for the most part. Moral of the story: research the credit card issuers' policies.

A further update regarding minimum purchases:

In the US, merchants will be allowed to require a minimum purchase of up to $10 for credit card transactions. (I am guessing that prompted the Visa rule change mentioned above.)

More detail can be found here in this answer, along with a link to the text of the bill itself.

Some large merchants do not give discounts for cash payments as this does not work out any cheaper for them, vs Credit Card payments. In Credit Card typically fees given to all the 3 parties (Merchant bank, Issuer Bank and Visa) would be around 3%.

If cash payment is made, and the amounts are large (say at Walmart / K-Mart they have to deposit such cash at Banks, Have a provision to Storing Cash at Stores, People to count the cash. So essentially they will have to pay for

1. Cash Officer to count,

2. Bigger Safe to store,

3. Transport & Security & Insurance to take Cash to Bank

4. Plus Banks charge around 1% charge for counting the large cash being deposited.

5. This cash would be in local branch where as the operations are centralized and Walmart/K-Mart would need the money in central account, it takes time to get it transferred to a central account, and there is a fee charged by Bank to do this automatically.

On the other hand, smaller merchants would like cash as they are operated stand-alone and most of their purchases are also cash. Hence they would tend to give a discount for cash payment if any.

1. Yes, merchants are charged. Visa/Mastercards charge 1 to 2%, of which some part goes to the Visa/MC and the rest to the issuing bank (if you have an HDFC Bank Visa card, HDFC bank is the issuing bank. And yes, you can get a discount from the merchant - while it probably isn't allowed by Visa/MC, some merchants still provide discounts for cash. But you won't get it at places like supermarkets or large brand retail.

2. Late fees + charges can be huge. In multiple ways - first, they all seem to charge a late fee of Rs. 300-500 nowadays, plus service tax of 10%. Then, you will pay interest from the bill date to the eventual payment date. And further, any new purchases you make will attract interest from the day they are made (no "interest-free" period).

Interest rates in India on CCs are over 3% a month, so you really must get rid of any open balances.

I've written a longish piece on this at http://in.finance.yahoo.com/news/The-good-bad-ugly-credit-yahoofinancein-2903990423.html

Its not just late fees. The fees for going over your credit limit are exorbitant. To make things worse, they will rearrange the transactions you make during a day so that they can charge you more by making more of them fail.

There are 2 parties when we say credit card companies: The bank that gives you a card & VISA/Mastercard

For a Bank the revenues generally come from:

1. Fees from merchants for POS terminals which many people have explained is in the range of 1-2% of the purchase.
2. Annual fees(if any) charged on the card
3. Late payment fees & interest charges in case someone is not able to pay on time or chooses to pay the Minimum amount due.

For VISA/Mastercard the revenue is from:

1. Service revenues from banks for their participation in card programs
2. Data processing revenues from banks for authorization, clearing, settlement, and transaction processing services
3. International revenues from transactions where the cardholder issuer country is different from the merchant’s country

P.S. Have not covered American express here but in short it is a combination of the above 2 models

Your reasons are the main ones, but I'm surprised nobody mentioned currency conversion fees as a third income stream. (4th if you count annual fees as mentioned by @eclipse.) Credit cards are very convenient for travelers, and can be used for online purchases which might not be in the same currency as your account. The credit card company will usually charge a fee for this. My credit card charges 1.75%, but different cards/banks/countries will charge different rates.

One thing that the other answers miss here is the interest they charge for EMI payments. In India, credit card companies usually charge from 10% to 15% interest for EMI purchase.

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To summarize, in India credit card companies earn from

1. Interest on EMI purchases.
2. Interest on late payments.
3. They charge interest for any cash withdrawn. There is no grace period for this.
4. Charging merchants. Normally this is around 2% in India. This is one of the reasons why many small shops in India stick to cash. In some cases this cost is transferred to the customer.
5. Fixed yearly charges such as account maintenance charges. Normally this is around 500 INR per card and is discounted if the usage exceeds a certain amount.
6. Premium cards - Many Indian banks offer premium credit cards that can cost as much as 5000 INR p.a. (10 times the normal charge). They usually come with perks such as coupons, or discounts on their partner services, etc...

Credit card companies make profit by collecting fees. Out of the various fees, interest charges are the primary source of revenue. When credit card users fail to pay off their bill at the end of the month, the bank is allowed to charge interest on the borrowed amount.

Other fees, such as annual fees and late fees, also contribute, though to a lesser extent. Another major source of income for credit card companies is fees collected from merchants who accept card payments.

Through the fees they get to collect, banks make a profit on their credit card business.