In the typical banking business model, interest income is associated with higher risks because it is subject to potential margin compressions. Fee income, by contrast, is associated with lower risk because it is thought to be more consistent, predictable and free from margin compression impacts.
When it comes to credit card programs, however, this rule of thumb is not always the case. The risk associated with fee income could be higher than expected if the credit card program is not optimized. Many of the fee income lines — such as interchange or late fees — within the credit card profit and loss statement are tied directly to variable expenses. These expenses may move in unpredictable ways and can increase profit margin compression risks.
Banks and credit unions must carefully weigh the options of choosing either a credit card program run in-house versus one outsourced to a third-party agent provider and take into account the impacts of profit margins and variability of fee and interest income.
Analysis of Card Program Interest Income
In the case of a credit card program, interest income is earned as a result of cardmembers borrowing money from the issuer to fund purchases. A credit card program’s interest income yield, or percentage of interest revenue on total balances, is determined by taking the weighted average APR (WAAPR), which is affected by whether the rate is fixed or varied based on an index, such as the published prime rate, and multiplying it by the revolve rate.
The product of this calculation, depicted graphically below, tells a bank or credit union how much interest income yield they will earn based on any given amount of balances outstanding across all of the APRs within the credit card program.
Credit card portfolio balances are divided into two groups of cardmembers: those who pay down card balances in full each month (“transactors”) and those who do not (“revolvers”). The revolve rate is the percentage of total balances of cardmembers who are revolvers versus transactors. The higher the revolve rate for the card portfolio, the higher the interest income yield. A lower revolve rate will in turn result in a lower interest income yield.
In addition, the WAAPR has a parallel impact on the interest income yield. The higher the average APR within the portfolio, the higher the interest income yield. The lower the average APR within the portfolio, the lower the interest income yield.
Costs of interest income
Naturally, there are costs associated with collecting interest income that comes from a credit card program. Banks and credit unions would be remiss to not consider the costs associated and how that may affect their program’s profitability in the short and long term.
The two primary costs associated with interest income are the cost of funds and charge-off reversals.
Cost of funds: A credit card program’s cost of funds refers to the risk associated with the cost of funds. The risk is related to the average life/duration of the funding source and the relative movement of the cost in relation to the revolve rate. As alluded to previously, cost of funds for a credit card program also depends on whether the portfolio has a fixed or variable APR structure.
Charge-off reversals (losses): Another cost related to interest income is charge off reversals, which are balances unlikely to be collected due to the borrower becoming substantially delinquent. These balances must be accounted for as they may eventually become permanent losses for the credit card program.
Analysis of Card Program Fee Income
Fee income is income earned by a bank or credit union from account-related charges. It can be divided into two primary components within a credit card program: direct fees and interchange fees.
Direct fees are charged directly to the cardmember for a service, convenience, or to make up for a missed payment.
Interchange fees are paid by the merchant at which the credit card is being used. Interchange income is determined by the transaction volume and is often viewed as a low-risk source of revenue. However, there are investments and expenses that are required to grow this revenue stream, so it may not be as low risk as it initially appears.
The most obvious investment to banks or credit unions associated with products within the credit card program are rewards offers. Stronger rewards propositions within a credit card program result in more value to the cardmember, higher level of spend on the card, and higher portfolio growth over time (new account growth). In theory, offering higher rewards values on a credit card program results in higher spend and portfolio growth.
The tradeoff is that rewards have a direct variable cost linked to the same driver as the interchange income: purchase volume. Many cardmembers nowadays expect robust rewards from a credit card program, however that doesn’t change the fact that such rewards are costly for issuers.
High-value rewards programs such as a 2% cash back reward, will single-handedly offset all interchange fees earned.
Credit card issuing is a complex mix of variable revenues and expenses that are driven by the overall card program’s product designs. More than one calculation must go into measuring card profitability. Whether it is interest income earned or fee income earned, many factors and assumptions introduce some form of risk to the bottom line. If a bank or credit union does not get the card program’s formula right, profitability is lost and any value of card issuing becomes a burden to the overall enterprise.
Banks and credit unions should take a critical look at calculating their credit card program’s overall profitability. One aspect to consider is using third party resources to dive deeper into factoring in all expenses tied to managing the card program. These expenses may be more extensive than the obvious costs.
Also, it is important to weigh the risks of unsecure credit card lending by comparing the true income to other loan assets. Many banks and credit unions find that the profits of self-issuing may not outweigh the inherent risks and hidden costs.
Partnering with a third-party provider may allow banks and credit unions to optimize their credit card programs while mitigating risk and the various costs associated with running a credit card program, including those that may be not so straightforward.
Read the White Paper: Evaluating Credit Card Profitability: Fee vs. Interest Income