Evaluating Credit Card Profitability: Fee vs. Interest Income
much interest income yield they will earn based on any given amount of balances outstanding across all of the APRs within the credit card program (figure 1). Credit card portfolio balances are divided into two groups of cardmembers: those who pay down card balances in full each month (“transactors”) and those who do not (“revolvers”). The revolve rate is the percentage of total balances of cardmembers who are revolvers versus transactors. The higher the revolve rate for the card portfolio, the higher the interest income
yield. A lower revolve rate will in turn result in a lower interest income yield. In addition, the WAAPR has a parallel impact on the interest income yield. The higher the average APR within the portfolio, the higher the interest income yield. The lower the average APR within the portfolio, the lower the interest income yield. Costs of interest income Naturally, there are costs associated with collecting interest income that comes from a credit card program. Banks and credit unions would be remiss to not consider the costs associated and how that may affect their program’s profitability in the short and long term. The two primary costs associated with interest income are the cost of funds and charge-off reversals. Cost of funds: A credit card program’s cost of funds refers to the risk associated with the cost of funds. The risk is related to the average life/ duration of the funding source and the relative movement of the cost in relation to the revolve rate. As alluded to previously, cost of funds for a credit card program also depends on whether the portfolio has a fixed or variable APR structure (figure 2). Charge-off reversals (losses): Another cost related to interest income is charge off reversals,
Analysis of Card Program Interest Income In the case of a credit card program, interest income is earned as a result of cardmembers borrowing money from the issuer to fund purchases. A credit card program’s interest income yield, or percentage of interest revenue on total balances, is determined by taking the weighted average APR (WAAPR), which is affected by whether the rate is fixed or varied based on an index, such as the published prime rate, and multiplying it by the revolve rate. The product of this calculation, depicted graphically below, tells a bank or credit union how
By Elan Financial Services
In the typical banking business model, interest income is associated with higher risks because it is subject to potential margin compressions. Fee income, by contrast, is associated with lower risk because it is thought to be more consistent, predictable and free from margin compression impacts. When it comes to credit card programs, however, this rule of thumb is not always the case. The risk associated with fee income could be higher than expected if the credit card program is not optimized. Many of the fee income lines — such as interchange or late fees — within the credit card profit and loss statement are tied directly to variable expenses. These expenses may move in unpredictable ways and can increase profit margin compression risks. Banks and credit unions must carefully weigh the options of choosing either a credit card program run in-house versus one outsourced to a third-party agent provider and take into account the impacts of profit margins and variability of fee and interest income.
Figure 2
Cost of funds impact on card program yield and ROA
Figure 1
Calculating yield from credit card interest
● Net interest yield ● ROA yield
12%
12%
10%
10%
8%
8%
6%
6%
4%
4%
12% Weighted average APR (WAAPR)
75% Revolve rate
= 9% Interest Revenue Yield
X
2%
2%
0%
0%
Cost of funds 0.25% 0.45% 0.65% 0.85% 1.05% 1.25% 1.45% 1.65% 1.85% 2.05% 2.25%
This graph illustrates the impact that changes to cost of funds have on net interest income and return on assets yields, assuming a fixed weighted average APR. Rising cost of funds results in lower net interest income and ROA. A low revolve rate will also reduce the hedging effect of variable APR pricing. The chart assumes a 10% gross interest income yield and starting ROA of 3.25%. A one point increase in cost of funds results in a ~10% decrease in net interest income and a ~30% decrease in ROA.
SOURCE: Elan © October 2021 THE FINANCIALBRAND
SOURCE: Elan © October 2021 THE FINANCIALBRAND
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THE FINANCIAL BRAND INSIGHTS WINTER 2021
THE FINANCIAL BRAND INSIGHTS WINTER 2021
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