Why Banks Offer You a Credit Card


Banks make money by loaning us cash and charging interest on that cash.

In the old days before computers, banks weren’t very good at forecasting if a borrower would default or not.

The next time you use your credit card try to remember that it is effectively a free 30-day loan.

This meant that fewer people qualified for loans and credit cards could never have existed because the banks would have considered them far too risky.

Today we have sophisticated credit models and mountains of personal data allowing banks to relatively accurately judge how good of a borrower you will turn out to be.

Sophisticated credit models allow banks to offer on-demand 30-day loans, also called credit cards, while still making a profit.

 

Interest is What Matters


Your credit card doesn’t charge you any interest if you pay your bill in full every 30 days.

Most credit card users don’t pay off their bill and carry over some debt from month to month.

This is the scenario where the banks start seeing dollar signs, literally.

A credit card loan costs 12%-29.9%, more expensive than any other traditional type of lending. More expensive than a house, car, or even a personal loan.

All it takes to go from a free loan to one costing 30% a year is 30 days (a blink of an eye) and this is the reason so many credit card users get into trouble and spend hundreds more than they should, paying back their debts.

NOTE: Some high reward credit cards charge an annual fee ($100 or so) but you can earn much more in rewards than the annual fee will cost you simply by paying off your bill on time.

Example

A 1% cash back card that charges a $100 annual fee would require you to spend $10,000 a year to break even. Any more than that and the card is actually paying you to use it.

 

Bottom Line


The next time you use your credit card try to remember that it is effectively a free 30-day loan.

Longer than 30 days and banks are making a very attractive return on the money they let you borrow.

Credit cards serve a very important purpose, helping consumers establish a credit history, but if not used prudently, a credit card can be one of the quickest ways to ruin your finances.