Every time we use a credit card, we are essentially borrowing money, even if there is no immediate need for credit, and we intend to repay it quickly. Credit cards are unique in this regard as they allow for borrowing without a specific need for credit, unlike other credit products where borrowing is tied to a specific purpose or need.
Despite the absence of interest charges when taking advantage of the grace period offered by revolving credit cards and paying off last month’s purchases during the current month, there is still a cost of borrowing involved. Credit card issuers make money from these transactions through processing fees charged to merchants. These fees not only cover processing costs but also generate significant profits for credit card companies.
In some cases, credit card companies offer rewards to cardholders based on their usage. The more cardholders use their credit cards and generate profits for the credit card company through processing fees, the greater the rewards they receive. This system effectively allows cardholders to earn a percentage of these fees as a reward for using their credit cards.
Rewards Reduce or Eliminate the Short Term Costs of Credit Card Borrowing
Credit card usage involves a cost of borrowing, which is typically captured in the form of processing fees charged to merchants by credit card issuers. These fees are spread across the entire customer base of the merchant by way of higher prices for goods and services. If a percentage of customers, say 1/3, use credit cards and the processing fee is 3%, then everyone shopping at that merchant would essentially pay 1% more for everything, regardless of their payment method.
However, credit card rewards programs can somewhat offset this cost for credit card users. For example, if a credit card offers 1% cash back, the user would be compensated for the 1% extra they pay due to the processing fees. This essentially means that non-credit card users end up subsidizing not only the cost of credit card transactions but also the rewards given to credit card users.
If merchants were to make the processing fees transparent and pass them on directly to credit card users, it might lead to market segmentation, with some stores trying to attract more cash and debit customers by offering discounts. Some gas stations have tried charging more for credit card purchases, but this approach hasn’t been very successful overall.
This unique situation means that buying on credit with a rewards program can actually cost less than using another payment method. Credit card users can enjoy the benefits of short-term credit without additional costs, thanks to the way the costs are evenly distributed among all customers through pricing.
However, it’s important to differentiate between using a credit card for purchases (which involves transaction fees) and using it for cash advances or balance transfers (which typically involve immediate interest accrual). The latter falls under traditional borrowing, and interest starts accumulating right away because no transaction fees are generated in these cases.
Longer Term Credit Card Financing
Financing with credit cards can indeed be more expensive than other borrowing options due to their typically higher interest rates. Credit cards often carry interest rates around 20%, which may be competitive for some individuals who don’t qualify for better rates with traditional lines of credit or other borrowing products.
Traditional lines of credit and other borrowing options are usually priced based on risk factors. Clients with a strong credit history, capacity to repay borrowed funds, and other positive risk factors can often qualify for much better interest rates than what credit cards offer.
For short-term credit usage where no interest is paid, the interest rates on credit cards are irrelevant. Similarly, if one has access to other borrowing options with lower interest rates, the rates on credit cards won’t matter.
However, many people end up paying the higher interest rates of credit cards even when they have better borrowing options available to them or could easily obtain better rates if they pursued them. This may be due to a lack of financial education or a preference for the convenience of using credit cards, as credit card companies often make it easy to use their products.
There are credit cards available with more reasonable interest rates, and if someone plans to use a credit card for borrowing, opting for a card with lower interest rates is always a better choice to minimize interest costs. Being aware of the different borrowing options and their associated costs can help individuals make more informed financial decisions and choose the most cost-effective way to borrow when needed.
Credit Card Borrowing Costs More Because It Is Offered More Loosely
Credit cards have historically been offered more loosely compared to other forms of credit. In the past, credit card companies used to send out cards without requiring an application. Nowadays, while you need to apply and get approved for a credit card, the approval process is generally easier compared to getting approved for a lower interest traditional line of credit.
One of the main differences between credit cards and other forms of credit, like lines of credit or loans, is that the capacity to repay is less of an issue with credit cards, and in some cases, it’s even neglected altogether. Credit card companies may increase a cardholder’s credit limit over time without thoroughly assessing whether the individual can handle such borrowing capacity responsibly.
Income is often less of a factor in credit card approval decisions compared to other types of credit. Credit card companies may be more lenient in approving applications based on a cardholder’s credit history with them rather than solely focusing on their income and capacity to repay.
Moreover, credit card companies may be less concerned about a cardholder’s overall risk exposure concerning credit limits. In some cases, individuals can qualify for multiple credit cards with additional borrowing capacity even if their present capacity may not support the total borrowing limits they have accumulated. This is less common with traditional lending institutions like banks, as they are more cautious about a borrower’s total credit exposure and may be hesitant to extend additional credit if it could put the individual at risk of overextending themselves financially.
Credit card companies are more willing to overlook this concern, and even if an individual already has a substantial credit limit, they may still approve them for additional credit card borrowing capacity, often at similarly high-interest rates. The higher rates on credit cards justify the added risk to some extent from the perspective of credit card companies.
They May Be Less Careful, But You Still Need To Be Careful
When borrowing from a bank, they typically take a more conservative approach and assess your financial situation to ensure you can handle the debt responsibly. However, with credit cards, the ease of borrowing can lead to a situation where people borrow more than they can comfortably repay.
Credit cards offer a considerable capacity to borrow, and it’s crucial for individuals to exercise self-discipline and avoid borrowing more than they can handle. While credit card companies may not always proactively work to limit your borrowing capacity, it becomes the responsibility of cardholders themselves to ensure they don’t accumulate excessive debt.
Having the ability to borrow can be advantageous, providing financial flexibility and acting as a form of protection during emergencies. However, it’s essential to use this capacity wisely and avoid situations that could lead to financial difficulties.
Some individuals may underestimate the potential consequences of accumulating high credit card debt. The interest rates on credit cards can be quite high, and carrying a large balance can lead to significant financial strain. It’s essential for people to be mindful of their credit limits and consider reducing them if they believe they might be tempted to borrow beyond their means.
Maintaining self-discipline and being mindful of spending and borrowing habits can help individuals avoid getting into overwhelming debt situations with credit cards. Being responsible with credit card usage is crucial to maintaining good financial health and avoiding unnecessary financial stress.
