This Is Why Credit Card Interest Rates Are So High
Timestamps are as accurate as they can be but may be slightly off. We encourage you to listen to the full context.
Podcast Summary
In this episode of Bloomberg's Odd Lots podcast, hosts Joe Weisenthal and Tracy Alloway explore the surprisingly high interest rates charged by credit cards with finance professor Itamar Drechsler from Wharton. The conversation examines why credit card rates average around 23% (09:12) when other forms of borrowing are much cheaper, and breaks down the components that drive these high costs. (07:05)
• The main themes focus on the economics of credit card lending, the surprisingly high operational costs driven by marketing expenses, and the limited price sensitivity of consumers in this market.
Speakers
Joe Weisenthal
Co-host of Bloomberg's Odd Lots podcast and Bloomberg Markets Live blogger, known for his analysis of financial markets and economic trends.
Tracy Alloway
Co-host of Bloomberg's Odd Lots podcast and senior reporter at Bloomberg, specializing in credit markets, derivatives, and financial innovation.
Itamar Drechsler
Finance professor at Wharton School and former Federal Reserve researcher who specializes in banking, monetary policy, and macroeconomics. He co-authored recent research on credit card interest rates and has previously appeared on the podcast discussing banking regulation.
Key Takeaways
Credit Card Defaults Don't Explain High Interest Rates
While credit card borrowers (revolvers) have an average charge-off rate of 5.75% (10:47), this only accounts for a fraction of the 23% average interest rate. Drechsler explains that even accounting for risk premiums for unexpected defaults (around 5%), there's still a significant portion of the rate that cannot be explained by credit risk alone. This challenges the common assumption that high rates are primarily driven by default risk, revealing that other operational factors play a much larger role than most people realize.
Marketing Costs Drive Up Consumer Borrowing Costs
Credit card companies spend enormous amounts on customer acquisition, with American Express spending over $6 billion annually on marketing (34:16) and Capital One spending over $4 billion. This marketing expense is effectively passed through to consumers as higher interest rates. The research shows that banks with higher operating expenses (largely marketing) are able to charge higher average rates, suggesting that consumers are essentially paying for the privilege of being advertised to.
Consumers Are Not Rate-Sensitive in Credit Card Borrowing
Despite the availability of much cheaper alternatives like personal lines of credit from the same institutions and significantly lower rates at credit unions, most consumers don't seek out these options. (25:34) The CFPB maintains a spreadsheet of credit card rates where credit union cards are consistently the cheapest, yet they have minimal market share because they don't advertise extensively. This demonstrates a fundamental lack of price sensitivity in this market that wouldn't be tolerated in more efficient financial markets.
Credit Cards Generate Exceptional Returns for Banks
Credit card operations deliver return on assets (ROA) of 3.5-4% compared to the typical bank ROA of 1.2% (06:07). This makes credit card lending one of the most profitable banking activities, which explains why so many institutions want to enter this market. The high profitability stems not just from interest income but also from interchange fees (averaging 1.8% of transactions), though about 85% of interchange revenue is passed through to consumers as rewards.
The Interchange and Rewards System Creates Powerful Network Effects
The credit card ecosystem involves complex fee structures where merchants pay interchange fees (08:39) that largely get passed through as rewards to cardholders. This creates a network effect where consumers want to stay within the rewards ecosystem even if they're not rate-sensitive. About 85% of the $150 billion in annual interchange fees (19:20) gets returned as rewards, creating a system where non-card users effectively subsidize the benefits received by card users.
Statistics & Facts
- About 60% of credit card users actually revolve their balances rather than paying them off each month (07:05), meaning they pay interest on carried balances.
- Credit card interest rates average 23% (09:12), while the average charge-off rate is only 5.75% of balances, showing that default risk explains only a fraction of the high rates.
- American Express spends over $6 billion annually on marketing (34:16), making it larger than Nike and Coca-Cola in marketing expenditure, while Capital One spends over $4 billion annually.
