Legendary investor Warren Buffett once advised a woman seeking investment tips to first pay off her credit card on which she paid 18% annual interest. “It’s going to be way better than any investment idea I’ve got,” he told her. U.S. credit card debt is rising and at last count exceeded $1.2 trillion, but half of the 42% of Americans who worry about their card debt do nothing about it.
But the top-of-mind question among credit card users is: Why do they pay overly stiff interest rates? Credit card interest rates average 23% — higher than any other type of loan or bond, according to a recent paper titled “Credit Card Banking” by Wharton finance professor Itamar Drechsler and other experts. The other authors of the paper are Hyeyoon Jung, a financial research economist at the Federal Reserve Bank of New York, Columbia Business School professor and Wharton PhD Dominik Supera, and Wharton doctoral finance students Weiyu Peng and Guanyu Zhou.
The authors analyzed four potential explanations for the high credit card rates. One, they are compensation for average default losses. Two, they cover the high costs of credit card “rewards,” which banks pay in cash or airline miles. Three, they price in a large default risk premium, because the risk of unexpected defaults cannot be diversified away and is high during bad economic times. And four, banks are able to charge high rates because they have market power.
Marketing Expenses Are the Culprit
The authors found that one of the main reasons for high rates was the amount of money card issuers spent on marketing (“customer acquisition”) to build their brands and thereby attract customers and achieve pricing power. The study’s other findings support the case that operating expenses of card issuers — a large portion of which is marketing — are a major contributor to the high interest rates. For instance, customer defaults are 5%, but even as they are high, they explain only about a third of the high credit spread in credit card interest rates. Card issuers also price in a default risk premium of 5.3%, which is similar to the risk premium priced into high-yield bonds.
When the paper’s authors analyzed operating expenses, they found clues to what explains another large component of credit card rates: Banks incur high operating costs to build a franchise and hence obtain market power, especially for their credit card operations. A large part of those expenses is in marketing. Credit card banks spend between 1% and 2% of their assets annually on marketing, which is about 10 times what other banks spend, the paper noted.
“This is why the largest credit card banks, Capital One and American Express, are among the biggest marketers in the world, with marketing budgets as large as those of consumer products giants, and prolific advertisers, such as Nike and Coca-Cola,” the paper stated.
“It’s more than about the cost of providing credit,” Drechsler said, referring to the costs for banks to raise deposits and disburse them. “Credit card users end up essentially paying for those customer acquisition costs in marketing, because that’s what they’re responding to rather than the interest rate.” Surprisingly, card users respond more energetically to rewards features than to rates, he pointed out. “It just tells you what’s driving the economics of this sector.”
“Credit card users end up essentially paying for those customer acquisition costs in marketing, because that’s what they’re responding to rather than the interest rate.”— Itamar Drechsler
The authors arrived at those findings after an exhaustive analysis of data on 330 million credit card accounts at the 20 largest banks, which made up more than 90% of the total U.S. credit card market, to understand the economics of that business. They tracked card holders (or cohorts) on multiple parameters, including their FICO scores, credit limits, annual percentage rates, fees, rewards, and geographic location between January 2015 and December 2017, which allowed for at least six years of data for each.
The Vast Reach of the Credit Card Economy
The credit card economy they set out to understand is massive. Three-fourths of U.S. adults have credit cards, which total 580 million cards nationwide. They use credit cards as their primary mode of payment. In 2023, they used those cards for purchases totaling $6 trillion, or 70% of retail spending.
Other dimensions are also relevant: Not surprisingly, credit cards also are the main form of unsecured consumer borrowing, with 60% of card holders carrying revolving credit. The paper defined borrowers as those cardholders who carry their balances from one month to the next.
“Thus, for the majority of cardholders the cost of substituting consumption over time is given by the interest rate on their credit card, not the rate on a savings account or treasury bill, as often assumed in macroeconomic models,” the paper stated. In other words, for anybody trying to understand the cost of money for people with credit cards, the interest rates on their cards are a better measure than those on bank savings accounts.
Credit Card Lending: Rewards and Risks
According to the paper, credit card issuers enjoy a handsome spread of 18% over the Fed funds rate. That spread is also higher than those on commercial and industrial loans to firms, which average 2.25% over the Fed funds rate, on mortgage rates over treasuries (3%), and on high-yield U.S. corporate bonds, the riskiest of which earned a 4.21% spread over the yield on treasuries.
At the end of 2023, outstanding credit card balances totaled $1.1 trillion; of that, borrowers accounted for 85%, while the rest repaid their balances at the end of their statement periods. While those outstanding credit card balances seem large, they accounted for only 4.5% of bank balance sheets between 2010 and 2023. But they made up a disproportionate 16.6% of banks’ interest income on average during that period.
Banks also collect the majority of the so-called interchange fees (also called swipe fees) that their customers pay merchants when they use a network like Visa or Mastercard; smaller shares go to the credit card network and the merchant’s bank. Banks also give out rewards to their card users in cash or in the form of airline miles or points they can redeem in cash or against purchases.
The paper noted that the value of the interchange and rewards is large: In 2023 alone, the rewards expenses of the six largest card issuers totaled $67.9 billion. The researchers investigated whether the high APR spreads banks charge credit card users go to recoup those rewards expenses, but it turns out the rewards expenses are covered by the interchange income that banks earn.
“When you stimulate the economy or give people money, credit card users are the people that seem to really want to spend.”— Itamar Drechsler
The Oft-Ignored Personal Loan Option
With high credit card rates, Drechsler said it is actually cheaper for consumers to take out personal loans, which also provide more credit, in order to pay off their expensive credit card debt. In fact, most personal loans are for credit card consolidation, he noted. But for whatever reason, most credit card customers do not tap into that option. Banks don’t actively advertise personal loans, which could be one reason, he added.
According to Drechsler, that consumer behavior suggests that many credit card users are not sensitive to the rates they pay. “It leads to the equilibrium we see, which is that given that consumers are not that rate-sensitive, it pays for credit card banks to instead spend a lot of money on customer acquisition, or marketing, and charge a higher rate to recoup those costs,” he said.
But it isn’t as if banks are laughing all the way to their balance sheets. Credit card lending is unsecured and is the riskiest type of lending for them, the paper noted. Between 2010 and 2023, credit card defaults accounted for more than half (53%) of bank losses in an average year. Over that same period, credit card charge-offs at banks averaged nearly 3.96% of total balances, much higher than those for business loans (0.46%) and residential mortgages (0.43%). Charge-off rates decline almost in step with increases in FICO scores, from 9.3% a year for a FICO of 600 to 1.3% for a FICO of 850.
After accounting for operating expenses, non-interest expenses, and rewards payments, the study found that credit card lending still earns a 6.8% return on assets (ROA), more than four times the overall banking sector’s ROA. After accounting for the risk premium they estimate, the paper concludes that card issuers earned risk-adjusted excess returns, or an “alpha,” of between 1.17% and 1.44% relative to the overall banking sector.
But Drechsler put that in perspective. “I do think card issuers are profitable, but they’re making a lot less money than it looks like from the APR, because what they’re doing is fighting for that money by spending on customer acquisition,” Drechsler said. “And customers are acting like they care about the marketing a lot. The rates are much higher than they would be if people shopped around more and were sensitive to the rates they pay when they borrow on credit cards.”
A Good Business?
All considered, credit card lending is a good business to be in, Drechsler continued.
“There is a lot of action in the payments space, trying to get in front of consumers and make them loans to buy stuff,” he said. “A lot of companies want to get a piece of this; they think there’s a lot of money to be made here.”
In fact, the credit card space is getting disrupted by “buy-now, pay-later” firms such as Swedish firm Klarna, which recently listed in the U.S. after raising $1.37 billion in an IPO at a valuation of approximately $15 billion. They provide interest-free or low-interest finance for consumer purchases, payable in installments within specific time frames, and balance that by striking partnerships with merchants who could attract more customers with the easier financing.
A Spending Boom in the Offing?
What happens when interest rates start to fall, as the Federal Reserve’s recent actions suggest? “When you stimulate the economy or give people money, credit card users are the people that seem to really want to spend,” Drechsler said. “They could spend more.” As interest rates decline, credit card users could be tempted to spend more with their cards, a Wall Street Journal report noted.
Credit card users are thus an important barometer of the economy. “When analysts look at spending in the economy to see whether it’s picking up or going down, they often look at credit card spending,” Drechsler said. “That’s the most sensitive area to understand demand. It’s just that the price of that in terms of interest rate is way higher than we would normally assume for anything. I think that’s underappreciated.”
