You may have noticed that when the Reserve Bank changes the central interest rates that most banks will pass on the rate cut or rate rise for home loans, but not for your credit card.

How come?

The short answer is that it’s partly due to what a credit card is (it’s unsecured debt). Partly how banks structure their credit card business. Partly the cards on offer. And partly what we as cardholders do with our cards.

RBA Cash Rate vs Ave Credit Card Rate

Consumers are right to expect the average credit card rate to go up and down somewhat in line with the RBA–because up until 2010/11 they mostly did. Since then, however, the two rates began to detach and diverge from each other, with increasingly less correlation.

Consumers are right to expect the average credit card rates to go up and down somewhat in line with the RBA.

In the January 2014 to November 2015 period, Credit Card Compare data shows that the advertised credit card interest rates have hardly budged at all. In effect, the gap between the RBA’s 2% interest rates and the 17-20% average credit card rate has widened. This applies across all the credit card companies, whether they may be one of the big four, a challenger bank, mutual, building society, or credit union.

The credit card business can be lucrative for lenders. So, are they simply pocketing the margin at the consumer’s expense?

A quick refresher on the Reserve Bank

As the general conditions of the economy rise or fall, the RBA Governor and the Board make decisions to either raise, hold, or lower interest rates and cash rates. If you could picture a control centre for the entire economy, there would be three big red buttons on it–one for each of these three options.

Raise, hold or lower are pretty much the only buttons to press for keeping the entire economy on track.

In reality it’s not just as crude as pressing a button and hoping for the best. Various interdependent factors are taken into consideration during their decision making process–inflation, stock market performance, house prices, household spending, retail performance, business confidence, investment levels, employment levels, and the impact of international events, etc. all have a bearing on monetary policymaking.

Ultimately though, the RBA’s rate decisions do have at least some influence on the interest rates we as consumers pay for different credit products. Here are some averages you can expect to find on common financial products:

interest rates by loan type
* Accurate at the time of publishing Nov 2015

Hundreds of newspaper columns have drawn attention to the ongoing disparity in averages and more recently the issue has been raised within government. The argument tends to lie around these two questions:

  1. Q: How come credit card interest rates are much higher than other credit/lending products?
  2. Q: Why don’t credit card interest rates move up and down as much as the interest rates on a home loan?

Let’s look at these in more detail.

Q: How come credit card interest rates are much higher than other credit/lending products?
A: There are at least two main reasons. Credit cards are unsecured debt and banks offer credit cards that are much more diverse than they used to be with more lots of high interest rewards cards on offer.

1) Credit cards are unsecured debt

A home loan or car loan is secured debt. It is linked to an asset. So, for example, if you fail to keep up your home loan repayments, the bank can repossess your home and use the proceeds of its sale to recoup their losses.

Not so for credit cards. Your credit card is unsecured debt. And this makes a much bigger difference than you’d think.

unsecured-credit

Why? Because the bank is exposed to the risk that you could run up a credit card bill you can no longer afford to service and may decide to stop paying it back at any time. As they hold nothing as collateral, like your car or home, they know that should the worst happen and you default, they face a tough time getting it paid back. They may attempt to recoup their loss by using a debt recovery agency, which is a bad option for both parties–the bank will only recoup a few cents in every dollar owed, and the borrower has to deal with bailiffs chasing them down.

Money owed on the card isn’t secured against a car or some other valuable items that you own.

While the bank chases you for repayment (which you may or may not be able to do), they will report your missed payments to the credit bureaus and this will have a negative and long-lasting impact on your credit report. This will undoubtedly make it more difficult to get credit in the future–once a bad borrower, always bad, right?

Most of the risk is on the lender, therefore the interest rate is higher.

There are approximately 8 million cardholders in Australia, so there’s a risk that lots of them could get into serious trouble by getting into arrears or defaulting. Levels of delinquency reported by the Big 4 Banks in 2015 show that this appears to be under control, having remained stable at 1-3% of cardholders.

So this problem alone is probably not solely to blame for stubbornly high interest rates.

To put that in context, some of the major lenders in the United States had as much as 10% of their loan book default during the 2008 Global Financial Crisis. At 1-3%, Australia’s default rate is good by comparison.

2) Credit cards are more diverse

The credit card market is very dynamic and driven by consumer demand. A bank won’t simply issue a basic credit card and compete with all the other banks and lenders in a race to the bottom on who has the lowest interest rate. There is a lot of diversity within that 20% average rate you keep hearing about.

Looking at an average industry-wide credit card interest rate is only helpful to a limited extent and is probably less meaningful than it used to be. To really see what’s going on, you need to dig down into the various categories of the market to discover any truly meaningful numbers.

An average industry-wide credit card interest rate is only helpful to a limited extent.

Speaking of his revolutionary Model T, Henry Ford famously said that “you can have any colour as long as it’s black.”

Those days are long gone. And they aren’t coming back.

Not every consumer is the same. Which is why most banks have a range of credit cards aimed at different types of customers (spenders, savers and revolvers). And different product categories serving different needs: 0% purchase cards, 0% balance transfers, no annual fee, rewards and frequent flyers. There are a lot of overlapping product categories too, i.e. a credit card with a genuinely low ongoing ‘headline’ interest rate, but its main selling point is the 0% balance transfer offer.

number of cards by categories

What’s more, the bigger banks can have as many as four tiers of credit cards to cater of people of varying levels of affluence (classic / gold / platinum / black). The higher tier cards tend to have higher interest rates because they typically come with a basket of benefits.

credit card tiers

Another way to look at this is to isolate the cardholders who pay interest on their balance. This is something that the banks track internally. To do so, they the effective interest rate being paid by their cardholders carrying interest-bearing balances. It turns out that when you factor in the 0% balance transfer cards, the effective interest rate is usually significantly lower than the industry interest rates being advertised, and the contentious average interest rate for credit cards. ANZ have revealed that “the average [interest] rate paid to ANZ is expected to be around 11.5% this year [2015], which is substantially less than the 18.79% advertised rate on a typical rewards card and even lower than the 13.49% on a low-rate card.”

Headline interest rates are not a particularly good metric for evaluating relative competitiveness across loan products.

The Treasury concurs with this. They say that the headline interest rates are “not a particularly good metric for evaluating relative competitiveness across loan products” because only a fraction of cardholders pay credit card interest at any point in time.

In other words, the diversity of credit cards is distorting the numbers–but for a good reason.

Q: Why don’t credit card interest rates move up and down as much as the interest rates on a home loan?

A: As one economics academic put it, “credit card rates go up like a rocket and fall like a feather”. Over the past 23 years, an average of 112% of RBA cash-rate rises were passed on to credit card customers but only 53% of rate cuts were passed on.

rocket and feather

The accusation that banks are making more than their fair share of profit from credit cards is an easy one to make. Banks are banks, right?

The same suspicion that banks were pocketing the margin between the cash rate and the advertised rate applies to home loans. Banks have made it clear that they want to work to their own timetable and not move interest rates in line with monthly RBA decisions. However, the long term trend has seen the rates fall in line with the cash rates.

Four reasons why credit cards rates don’t track the RBA cash rate

Earlier this year, former Prime Minister Abbott said that the banks were being “greedy”. However, the Australian Bankers’ Association (ABA), which represents the big four banks, has rejected claims of “gouging” customers on credit cards.

Here are four reasons as to why credit card rates don’t go up and down with the RBA rate decision as closely as they used to.

1) The cost of funding credit cards

There’s a core cost of running a credit card business. Bankers call it the “cost of funding”. When you buy something at a shop, the shop is paid immediately, but you pay your bill 55 days later. In the interim, banks borrow money to fund their working capital.

the costs of cards

What other costs make up the other 75%? The answer:

  • customer acquisition;
  • servicing operations (technology, call centres, posting statements, processing payments);
  • late payments;
  • bad debt from defaulting customers and costs for debt recovery;
  • fraud protection;
  • rewards programs;
  • recharges from bankrupt retailers;
  • and on it goes.

The link between the RBA cash rate and the headline interest rates on cards is weaker than you’d think. It’s cold comfort for anyone struggling to pay of credit card debt and it doesn’t make for a good bank-bashing news article, but it does mean that what the RBA does with the cash rate plays a limited role when setting credit card interest rates. The cost of funding is much higher for home loans (85%).

The link between the RBA cash rate and the headline interest rates on cards is weaker than you’d think.

Of course, the true test of this will be when the RBA decides to lift interest rates. Will the cost of funding be quickly passed onto cardholders in the form of higher interest rates or fees? And if the trend for cardholders to pay off their outstanding debts was to continue, will the resultant lower cost of running their credit card business be passed on too?

2) Long term price setting

Consumers think short term. Banks think long term.

When deciding the interest rates and fees to charge, banks think in terms of long term economic cycles. Once they settle on the basic construct of your card’s rates and fees, it’s probably not going to change much.

Consumers think short term. Banks think long term.

CBA pointed to big picture macroeconomics in their Senate submission: “As credit cards are unsecured lending, they are sensitive to market pressures and the economic environment, particularly the unemployment rate. Credit card issuers need to take into account the economic cycle when setting rates.”

3) Less competition on headline interest rates. More competition on other selling points

A credit card can never fully detach itself from the from the headline interest rate on purchases because that is relevant to the core function of a credit card.

And herein lies the problem. Many banks aren’t trying to compete on the core interest rate on purchases.

Many banks aren’t trying to compete on the core interest rate on purchases

Instead of it being a race to the bottom on rates, banks want to differentiate their cards using important non-core features that cardholders will appreciate. The list is long, but key features include:

  • a better application process;
  • higher customer service standards;
  • rewards programs;
  • exclusive access to events;
  • concierge services available 24/7;
  • complimentary insurance polices;
  • useful smartphone apps and Internet Banking.

There are more. Lots more.

In other words, they want to be the Audi of the credit card market and not Great Wall. Sorry Great Wall.

Some banks want to be the Audi of the credit card world and not Great Wall

The other big development has been the pre-eminent rise of 0% balance transfers and rewards programs. In responding to the needs of cardholders, the credit card market revolves around three product groups; 0% balance transfers; rewards cards; and 0% purchase credit cards.

3-card-types-over-time

The increased focus on these categories causes a distortion in the basic ongoing interest rates when you look at it on the surface.

In other words, if banks did not offer 0% balance transfer cards then the average interest rate across all cards would probably track up and down inline with the RBA cash rate. But since there’s so many competitive balance transfer cards and strong uptake by consumers, the banks no longer can afford to move up and down on the purchase rate.

0% balance transfer cards by length

Overall balance transfers have been very positive for switched-on consumers. Whilst people now use their credit cards more in total volume, the average credit card balance being charged any interest has dipped below $2,000 from a peak of about $2,400 in 2011. Cards with balance transfer offers are one of the main reasons why this is happening.

What we aren’t likely to see much of are credit cards with very low ongoing interest rates under 14% and a 0% balance transfer for a long period and no annual fee. Cards that tick all those boxes would be very rare indeed… and very popular.

4) Not as much external pressure on banks from customers

There’s less pressure on banks to pass on rate changes for credit cards than for home loans because Australian homeowners owe about $1.424 trillion on residential home loans (1) versus only $50.5 billion on credit cards.

size of home loans vs cards

Proportionally, for every $1 owed on credit cards, there are $27 owed on home loans.

Therefore, it stands to reason that there’s much more pressure on banks from consumers, the media, and government to pass on any rate cuts for home loans ahead of cards. Plus there’s more scrutiny from APRA to ensure stability for the whole economy.

In terms of overall impact, what the banks do with credit card interest rates just doesn’t compare to property loans.

Maybe that will change.

1. (CoreLogic RP data)