Why credit cards have high interest rates?

  • author Wizi Team
  • 11-02-2022
Cardnomics is written by credit card industry professionals which helps you to take more informed view about credit cards.

Imagine your friend is asking you for a loan of Rs 10,000.

She promises to return the money in 5 months and it is for an emergency.

Both of you come to an agreement that - she will pay you a fixed amount monthly (say Rs 2,000) and since you are a financially sound person, you also say that you be compensated by the interest that will would have anyway given you.

She agrees.

So, she will pay Rs 2000+ some interest every month.

You are expecting a predictable behavior from her that she will pay 2000+interest every month. If she pays late, you may ask her to pay a little bit more like a penalty, so she pays on time next time.

Now imagine, the same friend is asking me to give her as much money as I can.

You assess her and tell, "I can give Rs 50,000 because you are working, have a steady job, I know where you stay, and you come from a reputed background."

If she uses the money wisely, you will keep supporting her.

One month she uses Rs 10,000 and pays 10,000 back promptly.

Next month she uses Rs 20,000 and pays 10,000 back only.

Third month she uses Rs 10,000 and pays only 5,000 back.

The credit usage and payment behavior of the customer is unpredictable and the amount is a variable.

The first scenario is typical loan scenario where it is predictable in terms of amounts, behavior - so by nature of the product it allows for better financial operations leading to lower interest rate (in the range of 12% to 24%)

The second scenario is a typical scenario of a credit card - imagine running a financing operation with many uncertainties around user behavior.

To compensate for this open-endedness of credit cards - there is a high finance charge or interest rates (range of 28% to 50%) which are levied to make the operations viable.

It is the very nature of product that provides boundaries for finance operations as well.

Hopefully this helps you to understand why credit cards have high interest rates compared to other financial products.

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