Are Debit Cards the Future?

A couple days ago, I got some pushback for arguing that the credit industry's tiered model amounted to a subsidization scheme: Credit card users who fall into debt get socked with fees and interest rates that in turn subsidize reward programs and low APRs for the credit users with a steadier cash flow. And, admittedly, my argument was largely speculative. But over at Felix Salmon's blog, some credit industry insiders add to the point. One writes:

In the recent past, I worked as a management consultant for some major credit card issuers. I can tell you that internally, these companies have a common term for customers who pay off their entire balance every month: “freeloaders”. These “freeloaders” aren’t necessarily unprofitable; some are, most aren’t, on average the group is mildly profitable, but not nearly as profitable as those who carry a balance. If you’re wondering how a “freeloading” customer can be unprofitable, there are several factors. For one, about 0.8% of the 2%-3% interchange fee goes to rewards, but a diligent customer can push that to 1.5% or more by optimizing the collection and redemption of rewards points. Beyond that, the credit card issuer finances everything the “freeloader” buys on the card for 15 to 45 days. Finally, there are the various expenses a customer costs: printing and mailing cards and statements, call center service, various card benefits, etc.[...] There are tradeoffs for everything. If hotels were banned from charging $8 for a minibar beer and $2/minute for phone calls and $25 for breakfast, the hotel chains would have to reevaluate their pricing structure. The result would probably be higher room rates and some closed hotels. If airlines had a price limit put on their business class seats, you can bet coach tickets would go up in price and the number of flights would go down. In these cases and in the case of credit cards, there is tremendous profitability in one customer segment that, to an extent, essentially subsidizes another segment because it is willing to pay ridiculous prices. The difference is that with airlines and hotels, the people paying the ridiculous prices are corporations and rich people, while in credit cards, it’s the stupid and the poor.

Another said:

I have worked for five years in the credit card industry for two major issuers, actually running and developing the financial models (NPV etc) on which the decisions were made to solicit and approve consumers...I have been intimately involved in decisions to lend more than $100B to US consumers through credit card. So, I am talking form reality here, not conjectures. Credit card industry works on a bar-bell business model. All the profits (mainly through fees and very very high interest stretching into 30% or more) are made form people below 650 FICO, all the assets (loans or balances) are from people from above 700 FICO. The industry is just a giant wealth transfer mechanism from poor people to wealthly people. The profits from below (subprime) serve to subsidize the interest rate and rewards cost of people in the ’super prime’ category.

Both of Salmon's correspondents say the same thing: The credit card industry isn't lying. The new rules passed by the Congress mean the end of a business model based around the failures of irresponsible card holders. That means credit card companies will have to flatten out their structure and make slightly more off the "good" cardholder who have been getting something of an easy ride in recent years.

But it's not clear how far they can go with that. It used to be that a credit card offered two things: Credit, with all its benefits and dangers, and convenience. But with debit cards, you can now have the convenience of plastic without the temptations of credit. I, for instance, use a debit card exclusively. And so do many others. On May 1st, Visa made headlines by saying that transactions made on Visa-branded debit cards had exceeded transactions made on Visa-branded credit cards. If credit card holders with good credit are suddenly exposed to higher interest rates and less favorable terms -- if the dangers of credit, in other words, enlarge -- the changeover to debit will probably accelerate.

(Photo credit: AP Photo/Paul Sakuma)