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%.
Our finance charge yield of 15% represents our revenue (we’ll exclude other revenue sources to avoid over-complication), but we need to factor in expenses. There are three main expenses to consider in credit card banking – operational, interest, and credit risk. Let’s start with credit risk. Net Charge Offs (NCOs) represent a significant expense in any unsecured credit portfolio. While charge-offs vary significantly depending on economic cycles, consumer mix, seasonality, product type, etc, a conservative, but reasonable, average loss rate for our hypothetical $1mm portfolio is 4%. Next, let’s look at our operational expenses. Most well-run credit card companies today have an efficiency ratio under 40% (efficiency ratio is a commonly used metric in banking that is calculated by dividing expenses by revenue). In this case, a 40% efficiency ratio equates to a 6% expense (i.e. 40% of our 15% yield will go to operating expenses). Lastly, we need to pay for the $1mm we have loaned to cardholders. Think of this as the expenses banks incur to collect deposits, pay interest on deposits, and maintain bank branches. This figure again varies significantly based on a number of macro-economic and business-specific factors, but a fair estimate for our scenario is 3%. When added together, our expenses equate to 13% (4% for net charge-offs, 6% for operational expenses, and 3% for cost of funds).
In our simple scenario, we now have a 15% revenue yield and 13% in expenses. The net return on our $1mm credit card portfolio is only 2%, despite a headline APR of 20%. In this case, the bank would generate $20,000 in profit for lending out $1mm completely unsecured.
While the above example was extremely simplified, it accurately outlines the basic economics of credit card P&Ls and should provide a insight into the reason why interest rates often exceed 20%. There are two key points to remember when considering interest rate pricing. First, headline APRs do not equate finance charge yields – actual interest paid by consumers is much less than the APR. Second, operating expenses, cost of funds, and credit losses offset 80% - 90% of gross interest income. As with any competitive business, the margins of success are much thinner than assumed – even with interest rates exceeding 20%. The public may think banks are asking to have their cake and eat it too, but the better analogy is that they’re all just competing for a slice of the pie.