Credit card operations have been one of the most lucrative lines of business for lenders for some years. The massive spread between funding costs and credit card interest rates has been consistent over the last 30 years and has even increased, irrespective of small competition in credit card issuance and several new entrants. To understand the profitability of credit cards, you’ll need to have insights into its profitability model.
The credit card profitability model relies on two primary drivers: the revenue and income drivers. While the revenue driver aims to generate profit from interest rates and charges, the expense driver covers fixed and variable costs.
Before starting a credit card business, it is essential you do your research on the profitability model.
Credit Card Profitability Model
A credit card is a type of payment card in which charges are made against a line of credit instead of the account holder’s deposits. When an individual uses a credit card to purchase an item, the individual’s account accrues a balance that must be settled every month. Although failure to settle one’s credit card debt early could lead to interest charges and late fees, a credit card can also help users build their credit scores.
How Do Credit Card Works?
Credit cards are rectangular pieces of plastic or metals that can be used to make purchases by swiping, tapping, or inserting your card into a card reader at checkout. In addition, many cards allow you to complete balance transfers, which provides individuals with the chance to get out of debt.
When you open a credit card, you get a credit limit that can range from a few hundred to a thousand dollars. You’ll be able to spend up to that limit.
When you buy, say, some fruits with your card, it will show up as pending on your account and post within some days. As soon as the transaction is posted on your account, your gross balance will increase.
Expect to get a bill from your card issuer every month that contains all the post purchases you have initiated during your billing cycle. To keep your account in good standing, you’ll need to pay at least the minimum amount by your due date (which is the same date each month).
What Is a Profitability Model?
A profitability model, or profit model, is a plan or prediction (according to financial data) for how long a business will make a profit. It consists of sales, cost of goods sold, overhead (fixed and variable costs), other expenses, and debt.
That said, let’s consider the profitability model of credit cards.
Profitability Model of Credit Cards:
The credit card profit model can be complicated; at its core, the model is one of the simplest. For novice risk managers and strategists or product managers, this is a place to begin. It should offer a framework to help one understand how a risk or marketing technique affects the levers that result in revenue or expense changes and, therefore, the entire profits.
Of course, we all know what profit is—the difference between the revenue and the amount spent on buying, operating, or producing something. From an issuer perspective, and especially a financial service firm, a clearer definition of profit is.
Profit = Revenue – Expense
Where:
Expense = Bad Debt + Capital Cost + Fixed Costs + Variable Costs’
Few terms mentioned above, for example, Bad Debt, Revenue, including Fixed Costs, will need to be analysed further into their derivers. So let’s begin with the revenue drivers.
How Banks Make Money From Nothing?
Revenue Drivers:
Of course, this is relatively easy, we all have at least one credit card in our wallet, we know outside of the amount we charge on the card we pay—interest on the balance we carry, we pay a yearly fee, or we pay a foreign transaction fee (for cards used outside the country), and if you are a business owner who accepts credit cards, you would also know about the interchange or swipe fee the bank charges.
So in simplest terms, three broad categories
- Interest income from customers
- Fee income from customers (yearly fee, foreign exchange fee, balance transfer fee, late fee, over-line fee)
- Interchange fee from business
To introduce another idea, customer behavior directly affects the kind of revenue the card issuer will get. Transactors, individuals who transact and pay their balances completely, will result mainly in non-interest income.
While resolvers (individuals who carry balances and fail to pay down in full) will increase the interest income component of revenue. It is clear, given the behavior, one of the above two segments (revolver) is inherently risker.
They can increase the bad debt rate and will also be linked with higher capital costs. There might be several techniques to reduce these rises. For example, the issuer might encourage the Transactors to resolve (through a balance transfer offer or teaser rates to encourage large ticket purchases). It is also crucial to understand the effect this will have on the fee income, mainly on interchange fees. One group will inherently result in a lower interchange fee than the other/
From a marketing and product design point of view, the behavior of the two groups above is crucial as not only would the programs been directed towards different risk buckets (ex-FICO lifetime loss bands), but one of the two groups will be rate agnostic and keener in rewards associated with the card.
Going back to the revenue equation:
Revenue= Fee Income + Interest Income + Merchant Swipe Fee
Where
Fee Income= (Annual Fee) * (Number of Card Holders)
Interest Income= (Average Resolving Balance) * (Interest Rate Margin) = [(# of transactions) * (Average Transaction Size) * (Percentage of Resolvers)] * (interest Rate Margin)
Merchant Swipe Fee = (Total Transaction Volume) * (Interchange Fee %) = [(# of Transactions) * (Average Transaction Size)] * (Interchange Fee %).
Other common drivers of cost can be expense drivers, credit losses, and operational losses (usually fraud losses). The fraud could be via any channel, online purchase, point of sale purchase, etc. The simplest way to measure this is via historical data.