As a taxpayer who has just promised billions of dollars to Citigroup, I have to stand and cheer at what they did with Granny Doc’s credit.
Really.
And it is no disrespect to GrannyDoc or her financial responsibility. If you care to step over the fold, I will explain why.
There are basically two kinds of credit available to individuals – secured (your mortgage, your car loan) and unsecured (your credit card). As its name suggests, secured loans have a better shot at recovering value if the borrower defaults. Obviously, secured loans are cheaper than unsecured loans - meaning you get a lower interest rate on home mortgages and car loans than you do on credit cards.
So, how do credit cards actually work for the bank that issued the card? There are four parties (three if you use Amex) involved in each transaction with a major credit card.
First of all, there is you, the customer.
The next is the merchant you bought stuff from.
The third is the credit card company – Visa or MasterCard
The fourth is the Bank that issued the card.
When you swipe your card, Visa gets a transaction from the merchant. They instantly send it to the issuing bank that confirms whether or not you have sufficient room in your credit for that amount. It gets approved, you take your stuff and you leave the store.
Visa pays the merchant. They transfer funds to the merchant a day or two later – and this is the important part – they hold back a small percentage of the transaction amount from the merchant. Usually, it is 1.5%.
Visa then sorts all their transactions by the issuing bank and sends an invoice to the bank for the total amount (including the 1.5%). Each bank reimburses Visa – but this time, they hold back roughly half the 1.5%. Essentially, Visa and the Bank split the 1.5% transaction fee, which came out of the merchant’s pocket.
So now you know why many stores will not accept Amex – Amex charges a 4% discount fee.
For your hundred-dollar purchase, the Bank paid Visa 99.25 and Visa paid the merchant 98.5.
This is the first, and primary source of income for banks from credit cards – the discount that merchants pay on all transactions.
The second source, of course, is you, dear cardholder.
You know, from painful experience the ways they make money from you – the fees, the interest on balances that are carried, the overlimit fees and everything else that is buried in the fine print.
So, if you are GrannyDoc, how does Citibank make money from you?
Well, she pays her balances off each month, so no hope of getting interest on unpaid balance. She probably pays it off on time, so no ridiculous late fees. The only way GrannyDoc is even mildly profitable to Citi is if she goes out and buys a lot (a whole huge amount) of stuff, so they can collect their 0.75%
If she spends 50,000 dollars a year, Citi gets $375 from her transactions. If she spends just $5000, they get 37 bucks – which would not even cover the cost of the part of the operation set up to support her. If they mail her a statement every month, that is about 5 bucks, just on the mailings.
So, when Credit card companies give large lines of credit to good customers like GrannyDoc, their only hope is that she spends the entire line and continues to pay it back on time every month.
But what if she doesn’t? What if she has a $50,000 line and spends $500 each month? Then Citi is sitting on a time bomb.
That is called an open line, in credit card parlance. The bigger the open line is, the larger the risk for the bank. Why? Because it is unsecured.
Let’s say GrannyDoc, with her $50,000 line and comfortable retirement, decided to make her retirement even more comfortable. She could move to Florida, buy a small house and start racking up her entire line with stuff she always wanted in retirement – a boat, large screen TVs, some fancy furniture and then promptly stop paying her card. Her credit rating gets trashed, but what if she does not care?
As a taxpayer, you and I just funded GrannyDoc’s boat. Do you feel better now?
Which is why I want every responsible credit card issuer to very carefully manage open lines. They are ticking time bombs. Good banks will keep the available limit quite close to the actual monthly usage. There are pretty sophisticated statistical techniques to figure out spending patterns. It is known as behavioral scoring and it only has a passing resemblance to your FICO score.
Oh, and by the way, if GrannyDoc made a quick phone call to Citibank and requested her line be increased by 10K, they probably would have obliged.