A deep dive into the economics of credit card P&Ls and the market forces driving interest rates.
Cake was being served for my nephew’s 16th birthday when the conversation turned sour. President Trump’s Truth Social post about capping credit card interest rates at 10% had recently dropped and the country was abuzz with talk of dramatic savings on their monthly bills. A member of the family was visibly upset as the discussion turned to a debate – why in the world does any company need to charge more than 20% interest on a credit card? “Good for Trump”, the family member exclaimed. “It makes no sense!”. Since this was a birthday party, and not the Thanksgiving dinner table, I made a half-hearted defense of the market forces driving rates into the low-20s and then quickly changed subjects as my arguments fell on deaf ears.
Later that same evening I reflected on the discussion and realized my arguments were insufficient. To the uninformed, charging 20% or more on interest rates seems predatory. Credit card companies must be over-charging. I knew that the card industry was simply pricing for credit risk, consumer preferences, market dynamics, and regulatory oversight, but I needed a better way to articulate the point. The below scenario explanation attempts to do just that. All figures are generalized and rounded for simplicity, but the overarching narrative and economics are sound. Banks aren’t preying on consumers; they’re simply putting products in the market that meet consumer demand and achieve reasonable financial returns.
Let’s assume the average interest rate for a $1mm credit card portfolio is 20%. While it’s tempting to assume the bank is earning 20% interest on all $1mm, the actual, finance charge yield on this portfolio will be less than 20%. This is because many cardholders pay-off their bill each month and are never charged interest – these cardholders never revolve a balance. Banks also often offer cardholders lower interest rates in the form of introductory perks, balance transfers, or promotional deals. These balances, priced much lower than the “headline APR” also reduce the overall finance charge yield. For the sake of example, let’s assume the yield on this $1mm portfolio is closer to 15%.