How Credit Card helps generating profits ?

How Banks make Money through Credit Cards?

SHUCHI.P.NAHAR 

To understand how credit cards works, which customer segments it serves, what it offers to its customer segments, and how does it makes money from them, we need to get familiar with few terms. Credit cards classifies the banks as either Issuers or Acquirers. Issuers issue cards to the cardholders, whereas the Acquirers manage the relationship with the merchants.

The diagram below explains what happens behind-the-scenes when a cardholder presents a card for payment to a merchant.

What types of risk bank accepts?

Bank usually accepts three types of risk 
1) Credit 
2)Liquidity 
3)Interest rate and they get paid  to take on the risk.

Managing credit risk

Credit risk is the core part of the lending business . investors can get a sense of a banks credit quality by examining its balance sheet , loan categories , trends in non performing loans and charge off rates as well as managements lending philosophy.

When a cardholder presents a card for payment to a merchant, the payment request is forwarded to the acquirer. The acquirer contacts the issuer through the VISA network. The issuer shares the information on whether sufficient balance is available to carry out the transaction. 

The information is then routed to the merchant. In case sufficient balance is available, the payment is accepted. Else, it is rejected. The issuer bills the cardholder on a monthly basis. The cardholder pays those bills then.

What is ignored in the diagram the reality is explained below!

What the above diagram does not tell is how VISA and banks make money in the process. They make money from the transaction fees charged to merchants. To understand how it works, imagine a $100 payment from a cardholder to merchant. 

In case the merchant fee is 2.4%, the merchant would get $97.60 from the transaction. $2.40 would get unevenly split between issuer and acquirer, depending upon the interchange fee. In case of an interchange rate of 1.8%, the issuer will keep $1.80 and acquirer will keep $0.60. 

Issuer gets to keep more of the merchant fee because of a higher risk of payment default from the cardholder.

VISA makes money on payment volumes, transaction processing, and value-added services.

How individual makes money out of this process is explained below:

VISA creates value for all its stakeholders during the process. Cardholders’ benefit because of convenience, security, and rewards associated with card payments.

Merchants benefit from improved sales by offering payment method options to the customers. Banks get new revenue streams through card fees, late payment interests, and transaction fee cuts.

    Chart explaining the business model for banking companies

Income from Credit Card Interest and Merchant Fees

The primary way that banks make money is interest from credit card accounts. When a cardholder fails to repay their entire balance in a given month, interest fees are charged to the account. For any given account, the interest charged is equal to the card's periodic rate multiplied by the average daily balance and number of days in a billing period. The periodic rate is the annual percentage rate (APR) divided by 365. In the United States, the average credit card interest rate paid by interest-bearing accounts is 14.87%.

The second largest source of income for credit card companies are fees collected from merchants. When a retailer accepts a credit card payment, a percentage of the sale goes to the card's issuing bank. This is commonly referred to as the interchange rate. In the US, the average interchange rate is around 1.75%, though it varies from card to card and retailer to retailer. 

Credit card companies make money by collecting fees. Out of the various fees, interest charges are the primary source of revenue. When credit card users fail to pay off their bill at the end of the month, the bank is allowed to charge interest on the borrowed amount. Other fees, such as annual fees and late fees, also contribute, though to a lesser extent. Another major source of income for credit card companies are fees collected from merchants who accept card payments. These average out to approximately 1.75% of each transaction. Through the fees they get to collect, banks make a profit on their credit card business—approximately 4.04% of quarterly assets.

How Credit Card Companies Make Money or Earn Profit

1. Marketing Tie-ups

You know who is making money these days? Anyone who helps brand/companies extend their reach. With each passing day, it is difficult to generate business. You may check the financial results of the company. For example, brands are spending more on digital marketing because of its reach. The credit card companies have direct access to their customer base and can influence their spending. Therefore, credit card companies can help in both i.e brand promotion and to generate sales. It is very effective and potent tool to reach new customers. In other words, the objective is to increase sale. These tie-ups are in the form of freebies, cashback offers, EMI offers etc. Knowingly or unknowingly customer end up spending more on the credit cards. As per RBI data, HDFC Bank has issued 62.8L credit cards followed by ICICI Bank at 35L credit cards. SBI, Citibank, and Axis Bank are at no 3, 4 and 5 respectively.

2. Interest on Balance Outstanding

It’s a universal fact that interest rate on a credit card is highest among all forms of credit facilities even higher than private lending. It can be as high as 42% (annually) or 3.5% (monthly). According to industry estimates, more than 50% of the credit card balance outstanding is not paid on time. These customers are GOD for credit card companies. Let me clarify that it is not necessary that 50% credit card balance outstanding means 50% customers  are defaulting/delaying the payment. 

The amount should be considered in absolute terms only. I don’t want to make this post data heavy. Assuming everything remains equal. In this case, credit card companies are receiving half the payment (absolute) on time and there is a delay in balance half payment. Therefore for delayed payment credit card companies are charging 42% interest rate. 

To simplify, we can safely assume that credit card companies are earning interest of 21% of the total outstanding balance. In other words, the amount spent on a credit card by the customers is fetching an interest of 21% to banks. From which line of credit, the bank can generate interest income of 21%. Even if you adjust settlements and written off amount, my guess is that net interest income should be 18% or more.

3. Cash Advance Charges

The credit card users are aware that they can withdraw cash against credit card limit. Normally cash limit is 40% of credit limit. This cash limit can come handy in case of any emergency cash requirement as a short term loan. 

For example, if my credit limit is Rs 5L then i can withdraw a cash of Rs 2L from my credit card account. I have to bear transaction fees of 2.5% (Min Rs 300). Therefore, if i withdraw 2L then i will be charged transaction fees of Rs 5,000. Besides transaction charges, the bank also charges an interest rate of up to 42% (annually) i.e. 3.5% p.m. from the date of withdrawal until the date of full payment. 

This is one of the costliest loan option and a most profitable option for the bank to lend during an emergency to the customer.

4. Annual and Renewal Fees

This is normally paid by the customers whose credit card spend is low. In other words, credit card companies charge annual/renewal fees in case customer is using credit card below the threshold limit set by the bank. It helps to recover the cost of providing the service to low usage customers.

5. Miscellaneous Charges

Besides this, credit card companies also charge some miscellaneous charges like 
(a) Late Payment Charges 
(b) Charges on over limit. Normally 2.5%. 
(c) Payment return charges 
(d) Reward redemption fee 
(e) Cash processing fee 
(f) Reissue of card.

Sources: Nerdwallet.com

                Valuepenguin.com

                Nitinbhatia's Report 

                Investopedia 

                 

                                 SHUCHI.P.NAHAR