This is a follow-up to "Understanding the Financial Sector: Banks" and "Understanding the Financial Sector: Insurance Companies."
I find it amazing that investors and consumers alike do not fully grasp how the consumer credit markets operate, what companies are involved in the various aspects of the credit card market and how credit cards can be effectively used. Given that April is Financial Literacy Month, it's an opportune time to delve into these issues.
Credit cards enter our lives in many different ways. The process usually starts with a solicitation in the mail with an offer for a "zero percent balance transfer" if you open a
Or perhaps you see a sign by the store checkout counter, offering "10% off your first purchase" when you sign up for a
How many of you enjoyed
"No Hassle Reward" television commercials so much that you accepted their card offer?
Get the Green Card, the Gold Card, the Blue Card, the Plum Card or the Platinum Card from
. Get them all (!) and put together a rainbow of cards because "membership has its privileges."
But the card card introductions that really get under my skin are those checks I get in the mail for "cash advances."
Yes, there are many incentives and promotions that may lure you into opening a credit card account or borrow money, but most people never read the application or understand the terms of the lender's agreement.
It's important to note that not all cards are the same. There are basically three types of cards that are available to consumers: charge cards, credit cards and debit cards.
1. Charge Cards:
These cards allow the consumer (you) to purchase products and services, which are then aggregated on a monthly statement and mailed to the "cardholder." Upon receipt of the statement, the cardholder has to pay the charge card company the full amount by a due date. If the cardholder fails to pay, the charge card company will impose a late fee and may prevent the cardholder from making further purchases.
A dominant charge card is American Express. Another well-known brand is Diners Club, which is owned by
2. Credit Cards:
Similar to a charge cards, except the cardholder of one of these may pay the balance that's due over a period of time. The credit card company will charge the cardholder a high rate of interest consummate with rates charged on unsecured consumer debt -- except when an introductory "teaser" rate or balance transfer rate is offered. Often, only a small portion of the balance is due by a certain date. But failure to pay that minimum amount will result in late fees assessed over
the going interest charges.
Credit cards like these are frequently brought unto the consumer market by two of the most dominant issuers, large banks Chase and Capital One which may issue either
branded cards. The payments are then processed by MasterCard or Visa.
Discover Financial Services
issue their own brand of card, the Discover Card.
3. Debit Cards:
Unlike charge and credit cards, these cards allow a cardholder to make purchases that are immediately paid for via direct withdrawal from a traditional bank account (such as a checking or savings account). There is no extension of credit for debit cards, so no need to pay interest or to worry about due dates and minimum payments.
For as many banks that exist there are likely to be debit cards issued by those institutions (see "
Now before we get into how these card companies make money, here a few words of financial wisdom on personal credit card use.
It's very important to read the account agreement
you apply for a particular card. Some key questions that you want clear answers to:
Is there an annual fee associated with the card? If so, how much?
What is the minimum balance due policy or calculation?
What are the interest rates charges?
What are the terms of rebates, point plans, mileage plans and other incentives?
Then as a cardholder, carefully read the monthly statement and within the "process note," find out the following:
Are all of the charges are bona fide charges? If not, dispute any unauthorized activity.
What is the actual minimum balance due?
What is the termination date of any incentive plans such as "zero rate" financing?
Can you pay the bill by electronic transfer on the card company's Web site (for no extra cost)?
Issuers and Processors
So how do credit card companies generate profits?
Well, there are really two different types of companies involved in the consumer credit/charge card industry. Each one plays a vital role, but they are all too often mixed together by the media and uniformed investors, when discussing the consumer credit card business.
First, we have the card issuers - the banks and sometimes retailers like Wal-Mart or
that will "private brand" a card. These companies will issue one of the four major brands of cards - Visa, MasterCard, Discover Card and American Express. These cards may take the form of either a charge, credit or debit card.
With credit cards, the issuers actually pay for the cardholder's purchase (
) and in turn lend the money to the cardholder. Thus, the issuers are taking on the credit risk of the cardholder, betting that the loan will be paid back.
In order to fund the loan made to the cardholder, the issuer uses cash from its deposit base or borrows money in the
capital markets. Thus, the issuer is making the
spread in interest rates (rate earned from cardholders
rate paid on deposits or borrowings)
processing fees and costs
the costs of delinquencies and charge-offs.
The credit card companies love people who don't pay their full balance on the due date and get charged those exorbitant interest rates on the order of 18% to 21% (and higher).
On the other hand, these companies can't stand people like me who pay their full balances on time, as the companies lose money on my activity because I am essentially getting a free loan and the card company pays for the processing fees and overhead.
Some card companies will also charge annual fees for the use of their card. This is particularly true of charge card companies that do not earn interest by design, unless the cardholder does not pay on time.
Second, we have the processing companies. This is where confusion really reigns. While Visa and MasterCard are brand name cards that are issued by banks and other consumer-focused companies, these two giants are not card issuers. Visa and MasterCard do not take any consumer credit risk. These companies are in the business of
all card types for the issuers.
Each and every time a cardholder uses a card, the processors earn a percentage of the amount charged, plus a flat transaction fee. Thus, MasterCard's stock has been performing quite well (up around 114% over the last 12 months), despite problems within the broader credit markets. And Visa recently experienced a successful
IPO, which was one of the largest to ever take place.
Credit Cards & You: Final Words of Financial Wisdom
1. Avoid high interest charges and pay all credit cars on time. If you don't have the money, don't use a credit card. In those instances rely on a debit card.
2. If you need to use use credit cards, find cards with cash-back bonuses. For example, I use my
MasterCard at Exxon and Mobil stations, my
card at Hess stations and my
American Express card at Costco stores. I earn several hundred dollars a year by optimizing my card utilization.
3. Don't use credit cards for cash "advances" and simply rip up those "checks" that credit card companies send you.
4. Read and understand
the terms of any card agreement and carefully review each monthly statement.
5. Protect you privacy. Be careful how you use a credit card and to whom you provide your card information to. Only use secure Web sites for online purchases. And
respond to personal information "verification" requests from emails. This is "phishing" and it's a major source of fraud and identity theft.
At the time of publication, Rothbort was long MA, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.