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Rising interest rates can have a material impact on the credit card market. Funding costs (otherwise known as the interest expense) represent one of the largest expenses facing a credit card issuer. When funding costs increase, credit card issuers typically look for way to pass those costs along to customers.
Below is a summary of 3 key impacts that rising rates can have on credit card companies:
1. Credit card debt will immediately become more expensive.
American borrowers could face up to $2 billion of additional interest expense over the next 12 months alone and a higher minimum monthly payment.
For people in credit card debt, the impact of rising interest rates is typically felt immediately in the form of rising APRs. Most credit card contracts have variable interest rates tied to the prime rate. The prime rate is almost directly correlated to the fed funds rate. When it goes up so, too, follow credit card rates.
For example, a credit card contract often contains something like the following: We add 11.74% to 20.49% to the Prime Rate to determine the Purchase APR.
The Prime Rate is highly (almost directly) correlated to the Federal Funds Rate (as the graph below demonstrates):
When the Federal Reserve increases the Federal Funds Rate, credit card contracts will likely see an immediate interest rate increase.
Given that there is approximately $808 billion of credit card debt outstanding, American borrowers could be facing up to $2 billion of increased interest expense over the next twelve months.
As the federal funds rate increases, the minimum due should also increase immediately. The way that credit card issuers calculate the minimum due varies. The largest credit card issuers typically calculate minimum due in the following way:
- Minimum due = 1% of principal + accrued interest and fees
As the interest rate increases, so does the accrued interest and fees, which will drive the minimum due higher. However, the good news for consumers is that a relatively modest increase in interest rates of 0.25% would have a negligible impact on the monthly payment. A borrower with $10,000 of credit card debt would end up paying an extra $25 a year of credit card interest. Or, more simply, ever $1,000 of credit card debt would cost an extra $2.50 a year.
2. Generous 0% balance transfer offers could become less so
Credit card companies regularly promote generous introductory offers. In today’s market, it is relatively easy to find 0% intro balance transfer offers with no intro balance transfer fee. You can also find 0% for up to 21 months for the duration of the introductory period (but it may come with a fee — refer to the terms and conditions).
Credit card companies lose money on a balance transfer to gain new customers (like a cable company offering a bundled deal at a rock bottom price for one year to win new business). Although the customer does not pay interest for the duration of the promotional period, the credit card company still needs to bear the interest expense. As the federal funds rate (and therefore the prime rate) increases, the cost of the balance transfer promotion increases for the credit card company.
As rates continue to increase, it is possible that the 0% promotional offers could shorten in duration. Or, banks might have to increase interest rates further to cover the costs of the more expensive promotional offers.
3. Even rewards could be at risk – over time
Even people who do not use credit cards to borrow could see, over time, a change in offers from credit card companies. Some consumers use credit cards as a convenient form or payment and to earn rewards – but they never borrow money. These people pay their statement balance in full and on time every month, and are called transactors. According to a 2015 CFPB study, nearly 20% of customers are so-called ‘transactors’.
As rates rise, these transactors become less profitable to credit card companies. (They still make money from the interchange revenue, which is the fee paid by the merchant on each transaction). As transactors become less profitable, credit card issuers will start to think about how lucrative they want their rewards schemes to be.
Credit card issuers can consider reducing sign-on bonuses or other parts of the rewards scheme to offset the transactor margin compression.
Credit card companies offer generous introductory intro APR periods[FJ4] , which makes it possible for people to use a credit card without racking up interest charges for a certain period of time. Although we might not think about this as borrowing, it is.
Consumers who are paying their credit card in full and on time are still borrowing the money from the moment they make the purchase to the moment the payment is applied. Although the customer is not liable for the interest expense, the credit card issuer is still borrowing the money and needs to cover the funding costs.
What should a consumer do?
Credit card offers today are very generous by historical standards. If a borrower has credit card debt they are looking for ways to tackle, now is a great time to look for introductory 0% balance transfer offers. Although these offers will not disappear overnight, they could become less generous over time as rates rise.
And rewards credit cards have never been more rewarding. In a recent study by MagnifyMoney, another LendingTree-owned site, credit cards rewards have nearly doubled since the recession. If you have been with your credit card for a few years, now is a good time to see if there is a product that better fits your needs. A 0.25% increase in rates is unlikely to have a material immediate impact on credit card rewards. But if rates continue their upward trajectory, less lucrative offers are likely in the future.