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 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 it costs 5% to borrow the money to lend, and the balance sits with the cardholder for a year, the issuer earns 10% on the loan. This 5% difference is the "interest expense" and the 10% is the "net interest spread".
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 protecting the customers from fraud rings. Depending on the issuer, marketing programs are also a significant portion of expenses.
Charge offs
When a consumer becomes severely delinquent on a debt (often at the point of six months without payment), the creditor may declare the debt to be a charge-off. It will then be listed as such on the debtor's credit bureau reports (Equifax, for instance, lists "R9" in the "status" column to denote a charge-off.) It is one of the worst possible items to have on your file.[citation needed] The item will include relevant dates, and the amount of the bad debt.[16]
A charge-off is considered to be "written off as uncollectable." To banks, bad debts and even fraud are simply part of the cost of doing business.
However, the debt is still legally valid, and the creditor can attempt to collect the full amount for the time periods permitted under state law, which is usually 3 to 7 years. This includes contacts from internal collections staff, or more likely, an outside collection agency. If the amount is large (generally over $1500 - $2000), there is the possibility of a lawsuit or arbitration.
In the US, as the charge off 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 frequent flier points, gift certificates, or cash back as an incentive to use the card. Rewards are generally tied to purchasing an item or service on the card, which may or may not include balance transfers, cash advances, or other special uses. Depending on the type of card, rewards will generally cost the issuer between 0.25% and 2.0% of the spend. Networks like Visa or MasterCard have increased their fees to allow issuers to fund their rewards system. However, most rewards points are accrued as a liability on a company's balance sheet and expensed at the time of reward redemption. As a result, some issuers discourage redemption by forcing the cardholder to call customer service for rewards. On their servicing website, redeeming awards is usually a feature that is very well hidden by the issuers. Others encourage redemption for lower cost merchandise; instead of an airline ticket, which is very expensive to an issuer, the cardholder may be encouraged to redeem for a gift certificate instead. With a fractured and competitive environment, rewards points cut dramatically into an issuer's bottom line, and rewards points and related incentives must be carefully managed to ensure a profitable portfolio. There is a case to be made that rewards not redeemed should follow the same path as gift cards that are not used: in certain states the gift card breakage goes to the state's treasury. The same could happen to the value of points or cash not redeemed.
Fraud
The cost of fraud is high; in the UK in 2004 it was over £500 million.[17] When a card is stolen, or an unauthorized duplicate made, most card issuers will refund some or all of the charges that the customer has received for things they did not 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. In several countries, merchants will lose the money if no ID card was asked for, therefore merchants usually require ID card in these countries. Credit card companies generally guarantee the merchant will be paid on legitimate transactions regardless of whether the consumer pays their credit card bill.
Revenues
Offsetting costs are the following revenues:
Interchange fee
Interchange is the fee that a merchant’s bank (the “acquiring bank”) pays a customer’s bank (the “issuing bank”) in exchange for the benefits the merchant receives for accepting electronic payments at the point of sale. Card networks such as Visa and MasterCard act as a gateway between the merchant's bank and the customer’s bank for authorizing and funding transactions for the purchase of goods and services.[18]
Merchants do not pay the interchange fee as a free-standing charge, rather, they accept a lower payment for their goods or services when they accept electronic payment.[19] The difference between what they charge and what they receive is called a “merchant discount rate,” of which the interchange fee is a single component, often the largest.[20] When a merchant accepts electronic payment, the issuing bank credits the merchant's bank for the purchase, less the default interchange fee. The merchant's bank then credits the merchant for the purchase amount, less the negotiated merchant discount fee, which includes the interchange fee.
Interchange fees have a complex pricing structure, which is based on the card brand, the type of credit or debit card, the type and size of the accepting merchant, and the type of transaction (e.g. online, in-store, phone order). Further complicating the rates schedules, interchange fees are typically a flat fee plus a percentage of the total purchase price (including taxes). In the United States, the fee averages approximately 2% of transaction value.
These fees are set by the credit card associations,[21] and are by far the largest component of the various fees that banks deduct from merchants' credit card sales, representing 70% to 90% of these fees. In recent years interchange fees have become a controversial issue, the subject of regulatory and antitrust investigations. Only very large merchants such as Wa-Mart have been able to negotiate fee prices,[22] and while many merchants prefer cash or PIN-based debit cards, most cannot realistically refuse to accept the major bankcard association-branded cards. This holds even when their interchange-driven fees exceed their profit margins.[23] Some countries have established significantly lower interchange fees. The fees are also the subject of several ongoing lawsuits in the United States.
Interest on outstanding balances
Interest charges vary widely from card issuer to card issuer. Often, there are "teaser" rates in effect for initial periods of time (as low as zero percent for, say, six months), whereas regular rates can be as high as 40 percent. In the U.S. there is no federal limit on the interest or late fees credit card issuers can charge; the interest rates are set by the states, with some states, like South Dakota, having no ceiling on interest rates and fees, inviting some banks to establish their credit card operations there. Other states, like Delaware, have very weak usury laws. The teaser rate no longer applies if the customer doesn't pay his bills on time, and is replaced by a penalty interest rate (for example, 24.99%) that applies retroactively. So customers should be wary of these offers, that usually contain some traps.
Fees charged to customers
The major fees are for:
- Late payments or overdue payments
- Charges that result in exceeding the credit limit on the card (whether done deliberately or by mistake), called overlimit fees
- Returned cheque fees or payment processing fees (eg phone payment fee)
- Cash advances and convenience cheques (often 3% of the amount)[24]. Transactions in a foreign currency (as much as 3% of the amount). A few financial institutions do not charge a fee for this.
- Membership fees (annual or monthly), sometimes a percentage of the credit limit.
- Foreign Exchange Premium
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