Like any other business, credit card companies have to spend money to make money. The costs the credit card companies pay to run their businesses include interest expenses from their own borrowing, actual operating costs such as salaries and printing costs, promotional costs, rewards programs, fraud and costs involved with debtors who default on credit card accounts.
Credit card companies don’t absorb all of these costs on their own, they pass these costs along to their customers in various forms, including interest rates, fees and penalties. The current economic crisis and new federal regulations have increased credit card companies costs — the costs involved with defaults has become a particular problem in the last two years. With unemployment and home foreclosures at record highs, it is expected that credit card companies will soon be taking some of the largest losses that they’ve ever experienced.
When the banks that issue credit cards lend money through these cards, they usually borrow the money that they’re lending. They borrow the money at low-interest rates, and then lend that money to their borrowers at higher rates. For example, a card issuer charging 15 percent interest on money provided through a credit card may have borrowed it at about 5 percent interest, the 10 percent difference is the revenue the credit card issuer brings in through lending the money through the credit card.
Like other companies, credit card companies have expenses related to running their business, such as salaries for the executives, customer service reps and other personnel who run the business, mailing costs, printing costs and computer and telecommunications infrastructure.
In addition to operating costs, credit card companies also incur significant costs through promotional offers and rewards programs. Many credit card companies give their customers rewards such as frequent flyer miles, cashback offers, discounts from various retailers, etc. Experts have estimated that these rewards can cost between .25 percent or 2 percent of the interest spread credit card issuers earn as revenue. To cut costs, some credit card issuers engage in practices that make redemption of rewards difficult, such as tucking the redemption page on an out of the way corner on their Web site or by encouraging customers to redeem their rewards for less expensive merchandise, such as gift certificates rather than airline tickets.
Fraud and charge-offs are big costs to credit card companies. Charge-offs occur when a customer becomes very late on payments, usually about six months or more. At that point, the credit card issuer will likely declare the debt to be a charge off and begin the collection process. Most states give creditors five to seven years to collect debts. Bad debts are considered a normal part of the banking business, but also something lenders must buffer against by stockpiling a significant pile of cash and by charging customers higher interest rates. A significant number of charge-offs can impact the solvency of a bank or lender. The recent economic crisis has led to an increase in charge offs. According to Fitch Ratings, charge offs rose 1.12 percentage points from December 2009 to 11.37 percent, the highest level since a record 11.52 percent set in September 2009, and 54 percent higher than levels in 2008. Some economists fear that a large increase in credit card charge-offs will further undermine the economy and possibly cause an economic collapse.
Fraud can smaller, but significant costs to credit card companies’ bottom line. Fraud does not cost credit card issuers in the U.S., because U.S. law places the responsibility for fraudulent credit card use on the merchants who took the payment. Other countries make credit card issuers responsible for the costs of fraud. In the United Kingdom, it’s estimated that the cost of credit card fraud in 2004 totaled more than $ 1 billion. Credit card fraud occurs when a card is stolen, an unauthorized duplicate is made or card information is used online to make purchases.
New federal regulations, particularly the CARD act have cut into credit card companies ability to offset their costs of doing business via fees, penalties and interest rate hikes. Credit card companies have responded by raising interest rates for all customers, among other fee and rate hikes that remain legal.
Credit card companies’ overall profit margin has dipped to 4.83 percent from 5.3 percent in the past year. While this may appear alarming, the credit card companies are still making billions in profits because of the staggering amount of money they handle. Profit margins are expected to pick up once the industry adjusts to the new regulatory environment, and as the economy recovers.