Why Banks Offer Higher Discounts on EMI Transactions Than Outright Purchases?

You open Amazon/Flipkart to purchase your favourite gadget. You notice you can get a discount if you pay using a credit card from a particular bank. And you get a higher discount if you purchase on EMIs using the same credit card. Interesting, isn’t it? Why higher discounts on EMI purchases? But first, why discounts at all?

Why Discounts on Credit Cards?

For the customers, discounts add value. You get the same item for less. You would want to own credit cards that frequently offer discounts on your favourite apps or websites. Thus, such discounts increase the attractiveness of the cards in the eyes of the prospects.

How many of us have signed up for Amazon Pay ICICI Bank and Flipkart Axis Bank credit cards because of the simple rewards structure and that you see the offers on these cards every time you purchase on Amazon or Flipkart? When a bank offers a discount on a certain app/website, such offers are visible to everyone and not just to the bank’s customers. And who does not love discounts? Hence, potentially more applicants for the bank’s credit cards. More credit cards, more usage, more MDR (discussed later), more income for the bank.

Plus, many of us own multiple cards and these cards compete for wallet share. And discounts by banks drive usage. While I am not an expert on behavioural science, you can develop affinity for cards that offer greater benefits (discounts, rewards, cashbacks, service) and are more likely to use those cards. In other words, the more you have used a card in the past, the more you are likely to use the card in the future.

Clearly, discounts are a win-win for both customers and banks.

Why Discounts Above a Certain Threshold?

The discount is applicable only if the purchase amount exceeds a certain threshold. This is clearly to tempt you to spend more.

And it works.

How many of us have spent Rs 1,000 more (on items we don’t really need) to get a discount of Rs 200? Plus, in the utopia of banks issuing credit cards, they don’t really want customers who don’t spend much. The more you spend, the more the bank makes. How?

In comes the MDR or the merchant discount rate. MDR is the cut/commission from the transaction amount that is retained by the banks (customer and merchant)/card networks (Visa/Mastercard). The merchant gets only the Purchase amount minus MDR.

For credit cards, MDR ranges from 2-3% of the transaction amount. That’s a lot of money. In fact, this MDR funds the interest-free credit period that you get on credit card purchases. The merchant bears the cost of interest-free credit. In the absence of MDR, the economics of credit cards won’t work. However, since the merchant takes the hit, you don’t care much.

For more on how banks make money on credit cards, refer to this post.

Who Bears the Cost of the Discount?

Likely the bank here. Or shared between the bank and the merchant. In the case we are discussing here, I think the bank will bear the lion’s share of the discount.

Why a Bigger Discount on EMI Purchases Than Outright Purchases?

You must have noticed this. 10% discount on outright purchase and 12.5% discount on EMI purchases. Sometimes, the discount is available only on EMI purchases. No discount on outright purchase. Why would a bank do that?

EMIs increase affordability. With EMI transactions, there is a propensity to spend more because you must pay in installments. You can buy things/experiences that you wouldn’t or can’t buy outright. Thus, EMIs make you spend more. And the more you spend, the more money the bank makes.

Higher engagement with a credit card. EMIs must be paid every month. Again, the more you have used a card, the more you are likely to use it in the future.

Fair enough.

But the bank could have offered the same discount on EMI (as on outright purchase). Why a bigger discount? Well, the bank can afford to. The bank earns interest on the EMI transactions. That in a way makes up for the higher discount.

Let’s consider an example.

You want to purchase a product with a listed price of Rs 20,000.

Your bank offers a 10% discount on outright purchase of Rs 10,000 and above.

At a listed price of 20,000 and a discount of 10%, you can buy it for Rs 18,000.

On EMI purchase, the bank offers a 12.5% discount.

If you buy on EMIs, your card is first charged Rs 20,000 * (1 – 12.5%) = Rs 17,500.

You opt for a 6-month EMI.

A few days later, your bank converts this to EMI at say 15% p.a.

EMI = Rs 3,045 for 6 months

You pay a total of 3,045 X 6 months = Rs 18,273.

FeaturesOutright purchaseEMI purchase
Bank earns MDRYesYes
Bank earns processing feeNoPossible
Customer affordabilityLowerHigher
Bank earns interestNo. You get Interest free credit periodYes. No interest free credit period

In both the cases, the bank earns the MDR (a portion of it). Slightly less in the EMI purchase since the transaction amount is lower.

In the case of EMI purchase, the bank earns the interest. And in some cases, the banks charge a processing fee too. For instance, ICICI Bank, HDFC Bank, and many other banks charge a processing fee when you purchase on EMIs. For short term loans, processing fees can have a big impact on the overall cost of the loan.

You can’t negotiate or opt out. It is just there. The upfront processing fee quickly covers a portion of the discount (delta). So, if the processing fee is Rs 199, it covers a part of extra discount of Rs 500.

Going back to the example.

The bank offered Rs 500 extra discount on EMI purchase.

Got back Rs 199 in processing fee. Effective excess discount is only Rs 301.

No interest-free credit period. Assuming you purchased on the first day of credit cycle, the bank earns 15% interest on Rs 17,500 for 30 days. That’s Rs. 219.

Now, the effective excess discount is only Rs 82. And for that, the bank will earn interest for another 5 months. Rs 554 in total over the next 5 months.

Does not look like a bad deal for the bank. What do you think?

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