Credit Cards as a Means of Borrowing

Every time we use a credit card, we borrow money in an arrangement to pay it back later, even though there may not be a need to borrow, and we may intend to pay back the money fairly quickly.

Credit cards are unique in that sense, as they are fashioned such that there does not have to be a need for credit to borrow. Any other credit product involves the need to borrow together with the capacity to borrow, which gets measured against the cost of borrowing to decide whether the borrowing decision will be a sound one or not.

Credit Cards as a Means of BorrowingWith short term credit card purchases, there still is a cost of borrowing, even though users may not pay any interest to borrow the money, which is the case when one takes advantage of the grace period that revolving credit cards offer.

So essentially, if one keeps their payments current on a monthly basis, paying off last month’s purchases this month, no interest will be charged on purchases by the credit card company. Credit card issuers do make money off of these transactions though, by way of processing fees that they charge merchants, and these processing fees aren’t just to cover the costs of processing, they generate big profits to credit card companies all by themselves.

In fact, a lot of credit cards will share these profits with their cardholders, on a usage basis, where the more you use your card and the more profit you generate for the credit card company by doing so, the greater the rewards. So in essence, you receive a percentage of these fees as a kickback for using their card.

Rewards Reduce or Eliminate the Short Term Costs of Credit Card Borrowing

If not for these rewards, there would still be a cost of borrowing involved with credit card usage, the percentage of transactions captured in fees by the credit card issuers, but this gets spread across the entire customer base of the merchant by way of higher prices.

So let’s say 1/3 of all customers of a merchant uses credit cards, and the percentage was 3%, then everyone who shopped there would pay 1% more for everything, whether you used a credit card or other means of payment. If you got 1% cash back though, then you would be compensated for this, and those not using credit cards would then bear the entire cost of short term credit card financing, which is pretty much what happens.

It’s even the case that non credit card users are subsidizing not only the cost of credit card transactions but the rewards to users as well, and if this market was transparent enough then merchants would simply add the processing fees to credit card purchases, but this is not the case, for better or worse. This is due to their not wanting to drive away credit card customers, as well as from non-credit card customers not being aware of this enough.

If they were more aware, then perhaps we would end up with market segmentation, with some stores perhaps looking to attract more cash and debit customers by offering discounts, and gas stations have done that in the past by charging more for credit, but this hasn’t worked that well generally.

This has all led to the unusual situation where buying on credit doesn’t cost more like it normally does, it actually can cost less, if there is a rewards program involved, and it’s not hard to get a rewards card of some type. Even without the rewards, one gets to buy on credit with no additional cost over using another means, given that the costs of this are transferred to everyone equally by means of pricing it in to what the merchant is offering.

If one uses a credit card for a non-purchase, to get cash for instance, or to pay off another debt, then no transaction fees are generated, and this is why interest accrues immediately with these transactions. Now we’re getting into traditional means of borrowing.

Longer Term Credit Card Financing

Financing with credit cards tends to be more expensive than other borrowing options, and in spite of the convenience involved in doing this, we need to be careful when we use credit cards in a way that we’re going to end up paying interest.

Credit cards generally come with interest rates in the neighborhood of 20%, which for some people might be reasonable competitively at least, if they don’t qualify for better rates with a more traditional line of credit or other borrowing product.

Traditional lines of credit generally tend to be priced according to risk, and with credit, the more risk that is involved, the higher the default rate will be. So higher risk situations will generally come with higher interest rates and vice versa.

So clients with a strong credit history along with the capacity to repay the borrowed funds and the other things that financial institutions measure to determine risk factors can qualify for much better rates than come with most credit cards.

If the cards are only being used for short term credit, where no interest is paid, then the interest rates on them won’t matter. If one needs to borrow and has access to a means of doing so at a lower rate, the rates won’t matter either.

A lot of people end up paying the higher rates of credit cards though when they have better options available to them, or could easily obtain better options if they wished. The reason why they often don’t pursue these other options may be due to a lack of financial education, or it just may be that they just don’t want to bother, and the credit card companies definitely work hard to make it easy to just use their products instead.

Some credit cards do come with much more reasonable interest rates, and if one is looking to use them to borrow, paying less interest is always better of course.

Credit Card Borrowing Costs More Because It Is Offered More Loosely

Credit cards have always been offered more loosely than other forms of credit, going back to the days where they just sent the cards out to people without any application needed at all. These days you do need to apply and get approved, but one can get generally approved for a credit card easier than a lower interest traditional line of credit.

So the credit score thresholds with credit cards are lower generally, but the biggest difference between credit cards and lines of credit or loans is that the capacity to repay is less of an issue with credit cards, and often is even neglected altogether.

So a cardholder might have a good history with a credit card and they may see their credit limit increased over time to amounts that they would be in serious trouble or worse if they used. Income is much less of a factor in these decisions than is typical with revolving credit.

Credit card companies are also far less likely to care what one’s overall risk exposure is credit limit wise and you can often qualify for further cards with further borrowing capacity even though your present capacity may not be able to support the borrowing limits you have now.

It’s true that banks will often not pay that much attention to this as well, but with banks it actually makes sense for them to overlook credit limits that involve higher rates than their products. So for instance if you can borrow $20,000 at 20% on credit cards, they are going to worry less about your getting yourself in trouble with their offering a $10,000 line of credit at a much lower rate, because the presumption will be that you will be replacing the credit card borrowing capacity with yours.

With credit cards though this often is not the case, and if one already has a limit of $20,000 and adds another $10,000 of credit card borrowing capacity, at a similar high rate, there’s more risk that one may borrow higher amounts. This doesn’t bother credit card companies as much and their higher rates will justify the risk to enough of a degree anyway.

They May Be Less Careful, But You Still Need To Be Careful

It is never a good situation to be overburdened by debt, and when you borrow from a bank, they will be conservative enough with their lending that they will look to keep you from getting in situations you can’t handle. Of course there’s always a risk of financial difficulties arising, such as having your income reduced, which will still place you at risk, but the idea here is that you should be able to handle your obligations if things don’t go wrong.

With credit cards though, you can get into trouble without encountering any of these financial difficulties, simply by borrowing too much. Just because you can borrow doesn’t mean you should, and this is especially true with credit cards, where one can amass a capacity to borrow that is not only beyond one’s means to pay without difficulty, it can be well beyond that.

So while it can be said that the credit card companies may not work as hard as they should to keep your risk exposure reasonable here, if one’s risk exposure is indeed going to be kept at a comfortable level, someone needs to do it, and this task does often fall upon cardholders themselves.

The capacity to borrow certainly has its benefits, and these benefits actually tend to be underappreciated by most people, and borrowing capacity is a form of financial protection to some degree anyway. Nonetheless, we need to make sure that we are looking to avoid situations that may get us in a lot of trouble by placing ourselves in a position where we can borrow too much.

If one has the proper amount of self-discipline then this may not even be an issue, and for a lot of people it isn’t, but for others they may want to look at their credit limits with their credit cards and perhaps look to reduce them so that they don’t end up borrowing too much, especially if they think they may be tempted to do so.

Credit card borrowing can be quite expensive, especially when you end up owing a lot of money on them, and it’s very important to look to keep from allowing them to get yourself in a lot of hot water.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: [email protected]

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