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The Good & Bad About Credit Cards

In recent times, credit card portfolios have been very profitable for banks, largely due to the booming economy of the late nineties. However in the case of credit cards, such high returns go hand in hand with risk, since the business is essentially one of making unsecured (uncollateralized) loans, and thus dependent on borrowers not to default in large numbers.

Costs

Credit card issuers (banks) have several types of costs:

Interest Expenses

Banks generally borrow the money that they then lend to their customers. As they receive very low-interest loans from other firms, they may borrow as much as their customers require, while lending their capital to other borrowers at higher rates. If the card issuer charges 15% on money lent to users, and pays 5% on that same amount, they are essentially making 10% on the loan. This 5% difference is the "interest expense."

Operating Costs

This is the cost of running the credit card portfolio, including everything from paying the executives who run the company to printing the plastics to mailing the statements to running the computers that keep track of every cardholder's balance to taking the many phone calls which cardholders place to their issuer to tracking down fraud rings to protect the customers. The expenses involved in taking phone calls from customers are usually the greatest of these categories.

Charge Offs

Some customers never pay their credit card bill. In any given year, anywhere from 4% to 9% of the money that a bank lends to its credit card customers will never be repaid. Some credit card issuers have had various troubles and have seen this number rise to over 20%. As this number climbs or becomes erratic, officials from the Federal Reserve take a close look at the finances of the bank and may impose various operating strictures on the bank, and in the most extreme cases, may close the bank entirely.

Rewards

Many credit card customers receive rewards, such as airline miles or cash back, as an incentive to use the card. Rewards are generally tied to spending money on the card, which may or may not include balance transfers, cash advances, or other special uses. These rewards rarely cost credit card issuers less than 0.25% or more than 2%, and in fact will usually run in the 0.5% to 1% range, as a percentage of purchases.

Fraud

Where a card is stolen, or an unauthorized duplicate made, most card issuers will refund some or all of the charges that the customer would have otherwise received, for things they didn't buy. These refunds will in some cases be at the expense of the merchant, especially in mail order cases where the merchant cannot claim sight of the card, but in other cases, these costs must be borne by the card issuer. The cost of fraud is high; in the UK in 2004 it was over £500 million [1]. Credit card companies generally guarantee the merchant will be paid on legitimate transactions regardless of whether the consumer pays their credit card bill.

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