June 24, 2024 

AmosWEB means Economics with a Touch of Whimsy!

AmosWEBWEB*pediaGLOSS*aramaECON*worldCLASS*portalQUIZ*tasticPED GuideXtra CrediteTutorA*PLS
AMERICAN ASSOCIATION OF UNIVERSITY PROFESSORS: An association of university and college faculty established in 1915 to protect academic freedom. Commonly abbreviated AAUP, this association is the closest thing university faculty have to a labor union. While it does engage in some collective bargaining functions with specific universities, similar to traditional labor unions, its primary function is to ensure that faculty maintain intellectual or academic freedom from political of social pressures.

Visit the GLOSS*arama

Most Viewed (Number) Visit the WEB*pedia

Charging Up Your CREDIT CARDS (aka Plastic Money)

Here's the scene: You've made your monthly stop (for the second time this week) at the Mega-Mart Discount Warehouse Super Center for a few essentials -- cashews, soap, licorice, garden hose, peanut clusters, color television, and a large inner tube for whitewater rafting. Do you pay with a check or whip out your Interstate OmniBank Platinum Diamond Express credit card? Credit card? Good choice. You don't actually have to PAY for the stuff that you're buying -- at least not right away. Your bank account is safe.

The Wonders of Plastic Money

Are credit cards one of the greatest inventions of humanity or are they the devil's evil plot to suck our souls into eternal servitude? Perhaps a little of both. Let's consider the possibilities.

As you probably know, credit cards are those 2 1/8" x 3 3/8" pieces of plastic that every bank in the nation and many of our larger corporations beg you to get on regular basis. If you're like most consumers, the mail brings at least one credit card application each day.

While they've acquire the cute nickname, plastic money, they really aren't -- money that is. They actually represent a standing line of credit -- or loan -- from a bank or similar institution. The credit card issuer has somehow determined that your credit is good enough that they're willing to lend you any amount up to a pre-determined credit limit. This arrangement certainly makes it easy to buy stuff -- just like money -- but it isn't money.

Here's why:

  • Money is an asset, or something that you own.

  • Credit cards, however, create a liability, or something that you owe.

When you make a purchase with money, you're trading one asset (money) for another asset (the stuff you buy). When you make a purchase with a credit card, you're creating a liability, or promise to repay a debt, in exchange for the stuff you buy. Eventually, however, you have to repay the loan by giving up an asset (money). A credit card does little more than let you postpone the inevitable payment. Credit cards fall into the same category as a car loan, mortgage, or home improvement loan -- all of which have to be repaid at some point.

Credit cards, though, are widely used in our economy because they have a useful purpose. Sometimes, even the most prudent, thoughtful, budget conscious consumer needs a quick loan. In fact, if you consider the assorted stuff that we buy with borrowed funds, you quickly realize that most of us could not enjoy our current living standards without borrowing.

Pre-Approved, $10,000 Credit Limit, Apply Now!

Many banks are eager to issue credit cards to all comers. The reason is quite simple: That's what banks do. While you might have thought that banks were in the business to protect your life-savings -- this is only partly right. Banks offer protection for your savings, certainly, but they do so to get their hands on it. When they get it, however, they lend it to others. And they don't make loans out of the goodness of their hearts, but in return for an interest payment.

Banks make a lot of different loans to businesses, consumers, foreign governments, and even other banks, but the loans they really like to make are to consumers in the form of credit cards. The reason is that credit card interest rates tend to be relatively higher than other interest rates.

For example, suppose Interstate OmniBank makes a $100,000 loan at 5 percent interest for Mega-Mart Discount Warehouse Super Center to expand its autoparts department. Interstate OmniBank Platinum Diamond Express credit cards, in contrast, carries a 20 percent interest. You needn't reach for you pocket calculator to see $100,000 in OmniBank Platinum Diamond Express credit card balances with 20 percent interest generates more revenue than a single $100,000 loan, at 5 percent interest.

So, What's the Deal with the High Interest Rates?

Credit-card interest rates tend to be among the highest interest rates in the economy for a couple of reasons. The first is risk.

  • Any interest rate depends partly on what we can term a basic interest and a little extra that's tied to the riskiness of the loan. The basic interest rate is what a bank needs to make it worthwhile to lend. It includes a real interest rate, an inflation premium, and administrative expenses. Like any supplier, a bank needs to cover its costs and earn some profit.

  • Some loans, however, have more risk than others. This risk occurs because banks stand a chance of losing revenue when loans aren't repaid. Credit cards are among the riskiest loans made by banks, and thus carry a big risk premium. Loans to larger, businesses, like Mega-Mart Discount Warehouse Super Center, tend to be less risky and have a smaller risk premium.

Let's say Interstate OmniBank needs to receive a basic interest rate of 5 percent on a loan -- when it lends $100,000 it needs to get back $105,000. Any lesser amount means that it can't pay its expenses, earn a profit, and stay in the business of being a bank. If it issues 100 credit cards at $1,000 a pop and all credit card balances are repaid, then Interstate OmniBank can charge 5 percent interest.

What would happen, however, if one credit card holder, charged the $1,000 maximum, then flew to the Cayman Islands without paying? The bank now has only 99 honest, paying credit-card holders, with balances of $99,000. To remain in business, Interstate OmniBank needs to recoup enough interest from the other 99 card-holders to cover the money lost from this one slime-ball.

The interest charged on the 99 remaining $99,000 credit card balances needs to be high enough to reach the banks required $105,000 total. The rate that achieves this goal is 6.06 percent, that is, 6.06 percent of $99,000 is $6,000. The 1.06 percent over and above the banks basic 5 percent rate is the risk premium. The risk premium is roughly 1 percent because 1 percent of the credit-card holders left for the Cayman Islands without paying.

If two credit card holders stiff Interstate OmniBank and head for the Cayman Islands, then the honest people are charged an interest rate of 7.1 percent. While this may seem unfair, it's necessary for the bank to stay in business.

Because a loan to Mega-Mart Discount Warehouse Super Center has less risk and is more likely to be repaid in full, it has a lower interest rate than OmniBank Platinum Diamond Express credit cards.

A Little Market Control Doesn't Hurt

While risk explains some of the higher credit card interest rates, it doesn't explain it all. Recall from Fact 4, Our Monopolized Markets, that the degree of competition helps determine price. Interest rates, as prices, also depend on the degree of competition among borrowers and lenders.

  • Competition among borrowers (card holders) is relatively greater than it is among lenders (banks) in the market for credit cards. Even though there seems to be a gadzillion banks offering credit cards, there are a million gadzillion potential credit-card holders. Lenders, as such, have greater control over the interest rates than do the borrowers. The banks have little pressure to force them to reduce their interest rates. If one potential card holder goes to another bank, a gadzillion others remain.

  • Competition for business loans, such as that to Mega-Mart Discount Emporium, in contrast, is not as great. There may be only a handful of businesses borrowing $100,000 from a handful of banks lending $100,000. In this case, a fair amount of negotiation is likely to take place. If Mega-Mart Discount Warehouse Super Center can't negotiate a satisfactorily low rate from OmniBank, then it will probably go to the Mammoth National Bank down the street.

A few words to the wise on getting and using credit cards:

Credit Card Tips

  • Most importantly for consumers who want to keep the bank from nailing foreclosure notices on the front door, credit cards are NOT money. They are loans to be repaid. You should borrow with credit cards only if you can pay it back.

  • Banks issue a lot of credit cards, some to consumers who are poor credit risks and won't be able to repay. This contributes to higher interest rates. All banks, however, are not equally willing to lend to deadbeats. The banks that are a little more careful in evaluating their potential customers, also offer lower interest rates. Shop around.

  • For this reason, be wary of "pre-approved" credit-card applications received through the mail. Banks that use this shotgun approach hope to get enough paying customers to offset the deadbeats. But, the paying customers often pay more. Try to get into a credit card with as many paying customers as you can, which again is reflected by a lower interest rate.

  • And while you can't change the number of competitors in the market, and make credit card borrowing more competitive, you can allow more competition into you own little part of the market. That is, don't confine yourself to selecting credit cards only from banks in your city or state. Let the banks throughout the country compete for your business. This will help keep interest rates lower for you and everyone else.

BUSINESS As Usualxxx Stealing A Few Moments For CRIME


[What's This?]

Today, you are likely to spend a great deal of time calling an endless list of 800 numbers wanting to buy either a large green chalkboard shaped like the state of Maine or a replacement battery for your pocket calculator. Be on the lookout for attractive cable television service repair people.
Your Complete Scope

This isn't me! What am I?

Before 1933, the U.S. dime was legal as payment only in transactions of $10 or less.
"It is not fair to ask of others what you are unwilling to do yourself. "

-- Eleanor Roosevelt, diplomat, activist

Unlisted Securities Market
A PEDestrian's Guide
Xtra Credit
Tell us what you think about AmosWEB. Like what you see? Have suggestions for improvements? Let us know. Click the User Feedback link.

User Feedback

| AmosWEB | WEB*pedia | GLOSS*arama | ECON*world | CLASS*portal | QUIZ*tastic | PED Guide | Xtra Credit | eTutor | A*PLS |
| About Us | Terms of Use | Privacy Statement |

Thanks for visiting AmosWEB
Copyright ©2000-2024 AmosWEB*LLC
Send comments or questions to: WebMaster