Credit card companies such as Discover Financial Services (NYSE: DFS ) , American Express (NYSE: AMX ) , and Capital One Financial (NYSE: COF ) have a big problem: Americans don't want to carry balances.
Just look at this chart, which shows revolving credit card balances since the Great Recession:
It turns out consumers just aren't interested at borrowing at rates as high as 20% per year. Can you blame them? After all, paying interest on a credit card is one of the worst financial mistakes you could ever make. For the credit card companies, though, lower balances cut into profits.
How the industry is coping with lower balances
This year, credit card companies are upping the ante to put their cards in your wallet. Discover offers its customers 5% cash back on up to $1,500 in online purchases from October to Dec. 1. American Express is working with Amazon.com (NASDAQ: AMZN ) to give away free Amazon Prime accounts to customers who sign up for its cards.
JPMorgan Chase (NYSE: JPM ) promised its Chase Freedom customers 5% cash back at Amazon and "select department stores."
The credit card companies of the world know that the fourth quarter is their time to shine -- their time to grab balances on which they can earn returns topping 20% per year.
How their marketing pays off
Anyone who collects 5% cash back or a free Amazon Prime account this year will benefit at the card company's expense, provided they pay off their balances on the next due date. Those who carry balances will help make the businesses -- and their shareholders -- even wealthier.
But these marketing plans aren't a one-off opportunity to grab balances. These promotions can pay dividends for years to come.
Let's use Discover as an example. The company reported that it paid a rewards rate of 0.98% in the third quarter, or about $273 million to customers who use its credit cards.
However, it generated revenue of $550 million on total transaction volume of $77.4 billion across its network in the same period. That amounts to an average take of about 0.7% on all transactions. It also earned about $1.5 billion in interest on $50 billion in credit card balances.
Discover would love to give away $273 million to generate more than $2 billion in fee and interest revenue over and over again. It's an investment the company would love to make hundreds of times per year.
Creating a perpetual revenue stream
There's an obvious reason credit card companies want you to use their cards online. Once used, retailers save credit card information for future use. At Amazon, for instance, I have three different cards plugged in to my account. When I make a purchase and pick a card to use, the credit card company gets a balance. If it's a Discover or American Express card, they also get the transaction fees.
So, for a small upfront investment, credit card companies can earn processing fees and gather balances in perpetuity. While Discover, American Express, and JPMorgan may lose money initially on heavy promotional activity, they secure their place in your account at department-store sites scattered around the Internet.
Each time you shop, your trusty credit card will be preloaded, ready to use. And for the credit card companies, that's a huge advantage in growing their market share. The more places they can encourage you to spend, the more likely you are to use their cards in the future.
Sure, all these promotions come at a cost, but it's hard to see how aggressive promotions today won't lead to big balances -- and big profits -- for years and years. American Express and Discover have an advantage on most credit card issuers, as they get paid twice when their cards are used: first on the transaction fees, and again when interest accrues on carried balances. The others just collect interest on the balances.
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