You do not pay any interest during the interest-free period on the credit card. But the bank cannot afford to lend you money for free. The bank must be compensated — two major ways and a few minor ways.
High Interest on Unpaid Amount
First, when you do not pay your bill on time, the banks charge a hefty interest rate and that more than makes up for interest-free period. But the banks offer credit cards only to those with good credit scores. And the borrowers with good credit scores will likely pay on time.
Therefore, expecting good borrowers to not pay on time cannot be a good business model. The banks can relax credit norms and get not-so-good borrowers into the credit card fold but then such borrowers may not pay back. The bank will experience more defaults and NPAs, which is an even bigger problem. Hence, the revenue model should be such that the lenders make money by offering interest-free credit to good quality borrowers.
Related Reading: Why Paying Credit Card ‘Minimum Payment Due’ Is a Bad Idea
Enter Merchant Discount Rate (MDR)
That’s where the second mode of revenue comes in. The merchant discount rate (or the MDR). MDR is a percentage of the payment amount that a merchant shares with the payment system for each card transaction.
So, if you swipe your credit card at a shopping mall, the merchant will share 1-3% cut with the facilitators. The facilitators in this entire structure are your bank, the merchant’s bank, and the card network (Visa/Mastercard/Amex). Since this revenue is transactional and not behavioral, this is a dependable source of revenue. The bank makes money every time you use a credit card. The bank’s share of cut/commission compensates for the interest-free credit period given to you.
Even with No-cost EMIs, the merchant offers a real time upfront discount and the bank offers a loan for the discounted amount at a normal interest rate. The discount is such that the loan EMIs add up to the original listed price. Hence the impression of No-cost EMI. And this is in addition to MDR for credit/debit card transactions. Hence, for your No-cost EMI, the merchant takes the hit. However, don’t think of the merchant as a victim. He gets more business. That’s one reason to be happy. You are happy as you can split your payment across 3-6 months and do not have to incur any additional cost.
The banks are happy since they got the interest and their share of MDR. Visa and Mastercard too earn their share of MDR and these are two of the most profitable companies in the world.
So, everyone is happy. What else do you need?
By the way, the merchants are even happier if you use UPI. Why? Because the MDR on UPI transactions is zero. UPI is not exactly comparable though, since UPI works by debiting your bank account. No credit is involved, but this might change soon. However, UPI transactions through credit cards will have non-zero MDR. And now you know why. We will see how UPI-credit card linkage pans out in future.
And Some Minor Ways
Processing fee is another way for the card issuers to augment income. The bank may charge a processing fee each time you opt for an EMI based payment (No-cost EMI or regular EMI). For instance, Amazon Pay ICICI Credit card charges Rs 199 (excl. GST) for each EMI transaction. ICICI charges the fee irrespective of the loan amount.
Additionally, the banks usually permit borrowers to convert their purchases into EMI (loans). Such loans have both processing fee and interest income. Processing fees sharply increase the effective cost for short term loans. We tend to ignore processing fee for small purchases and the banks love it. This is in addition to MDR and the interest income (for EMI transactions).
Processing fee is a regular feature for personal, car and home loans. This is a clever way for the banks/lenders to earn fee income. In many cases, the applicants cough up the processing fee even if the loan application is rejected subsequently.
In addition, there are annual fees and fees for late payments, cash withdrawals and foreign currency transactions on the credit card.
Now you know why the banks keep chasing good borrowers to sign up for their credit cards.
To summarize, these are the ways a bank makes money from credit cards.
- High interest on unpaid amount
- Merchant Discount Rate on transactions
- Interest on loans/EMI transactions
- Processing fee on loan/EMI transactions
- Fees (late payment, cash withdrawal, foreign currency transactions, annual fees etc.)
Why Are We Discussing This?
Credit cards have been around for ages. And their revenue models are transparent and known. Some argue that they are charging (both you and merchant) too much for the quick and reliable credit service.
As a customer, you don’t have to pay anything if you make your payments in full and on time. Then, why should you bother if the merchant shares a cut with the banks? Because, it is not so simple.
If the banks charge the merchants too much, the merchants have an incentive to increase the list price to recover costs. And since the prices must be the same, the cost goes up for cash/UPI payments too.
We are seeing this happen with restaurants on Zomato and Swiggy. There are reports of restaurants charging 10% more (on an average) for the same food item if you order using these apps (compared to you ordering directly from the restaurant). The restaurants are increasing prices to recover commissions paid to these delivery apps. While Zomato and Swiggy still add immense value by ensuring timely deliveries and bringing accountability, the customer bears an inflated cost.
At many small establishments, merchants ask you to pay 1-3% extra for using a debit/credit card for purchase. While this is illegal, the merchant is simply passing on his MDR cost to you. See, higher cost for you.
We are digressing and this is a discussion for another day. I hope competition will bring the costs down. Rupay cards, merchant UPI transactions (and widely anticipated UPI linkage to credit cards) are such examples. Let’s get back to the topic on hand.
Is There a Conflict of Interest?
There is no dearth of fintech companies willing to lend you money for all kinds of reasons. Low-cost or zero cost loans are fine, but these businesses must recover the cost of lending to you. To lend to you, the fintech must have borrowed from another lender. They can’t borrow at 10% and lend to you at 6%? That’s not a sustainable model.
Therefore, as a borrower, you must assess if the credit is truly low cost or is just advertised as such. Incorporate deliberately hidden/unadvertised charges to figure out the actual cost of loan. If the cost of the loan is indeed low, then ask yourself the question, how is the lender getting compensated?
Again, you might say, “Why do I care?” You should. Because there may be a conflict of interest.
If a lender offers you a zero interest medical loan for payment to a particular hospital, then the hospital must compensate the lender for such loan. And this brings the conflict of interest. Will the hospital now charge you more for sharing a percentage of revenue with the lender? Would you have paid less if you had paid cash or using your own funds? Will the hospital ask you to opt for unnecessary services/procedures to recover the payment to the lender? We already know hospitals have differentiated treatment cost estimates based on your choice of room (single/double/premium). Or whether you will pay cash or if you have health insurance cover. In fact, the pricing is different even for different insurers.
If you dive deeper into the revenue model of lenders, you can identify potential conflicts of interest. The conflict of interest may not necessarily be bad for you but it still warrants a deeper look.
Recently, I read about a fintech company offering home buyers 0% interest loan for up to 12 months for house down-payment. I wondered — how would they recover their costs? And you should too. Is there a potential conflict of interest? More on this in a subsequent post.