In a world of increasing capital requirements and intensifying regulation, banks are struggling to achieve double-digit returns on equity. Credit cards are one bright spot. In 2014, for example, Barclays earned a 5.1% ROE at the group level. Its credit card business generated a 16% ROE.
With those relative returns, it's understandable that banks want to grow their credit card businesses and are investing heavily in product development and marketing. It's likely that they will be able to continue generating big returns in the short term, thanks to cyclically low credit losses and funding costs in the aftermath of the financial crisis. Returns will probably normalize as credit losses and reserves increase through the natural credit cycle.
However, there is a much bigger long-term threat facing the credit card industry: marketplace lenders.
On the West Coast, a crop of startups without legacy earnings to protect are looking to disrupt an industry that has thus far failed to give consumers the value they deserve. Companies like SoFi, Lending Club and Payoff are offering loans with much lower interest rates than credit cards. In addition to lower rates, these companies are providing customers with a much more transparent product, thanks to the simplicity of a personal loan.
These companies are targeting the most lucrative credit card customers: people with large revolving balances paying interest rates in the high double digits. They are aggressively marketing their loans as a way to refinance expensive credit card debt.
It is well known that most credit card companies make little to no money on people who earn rewards and pay their balance in full and on time every month. They make some money on "occasional revolvers," who need the flexibility of a credit card on an infrequent basis. However, the real money is made on borrowers who build meaningful balances and become almost permanent revolvers at high double-digit interest rates.
The new marketplace lenders have their eyes set on these customers. In a traditional credit card business, the heavy revolvers subsidize the people who pay in full each month. However, in a personal loan business, there are no unprofitable rewards customers requiring a subsidy. Marketplace lenders also have a lower cost base.
These factors combined mean that borrowers can receive dramatically lower interest rates. Lending Club has disclosed that when they refinance credit card debt, the average Lending Club interest rate is 31% cheaper than the rate on the original credit card.
Part of my job involves giving talks on financial literacy. After my sessions, people regularly approach me and ask for help. Earlier this month, a woman in Georgia came to me with $27,000 of credit card debt at an average interest rate of 20%. Her monthly net take-home pay is $4,000. More than one month of her yearly salary goes toward interest on her credit card debt — despite her good credit score. I share the full details of her situation here.
I observed her applying for a loan with a new marketplace lender to refinance her credit card debt. From beginning to end, the process and price could not have been more different from those of credit card companies. She compared offers from three different marketplace lenders in about 20 minutes. She then agreed to open an account with one of them and take out a loan, saving over $1,000 of interest in the next 12 months alone.
Marketplace lenders also allow customers to check their interest rates and credit limits before taking out a loan — and without hurting their credit scores. By contrast, credit card customers are given a wide range of interest rates when they apply for new cards and no indication of their credit limits. If borrowers want to find out the credit limit and interest rate, they have to make a hard inquiry that lowers their credit score and commit to opening the account. What other product only reveals its price after you agree to buy it?
By allowing borrowers to see their credit limits and interest rates before they commit to taking out a loan, marketplace lenders permit customers to comparison-shop — a common practice among companies like Amazon and Kayak, and one that customers increasingly expect. And marketplace lenders have application processes that are even easier and quicker than those of credit card companies.
When I asked the woman in Georgia what she planned to after refinancing her debt, she smiled and answered immediately: "I am going home and cutting up these cards." I'm betting more Americans will soon follow her lead.
Nick Clements is a co-founder of MagnifyMoney.com, a price comparison business for consumer financial products. He previously served as the managing director of the Barclaycard UK consumer credit card business and held several risk director roles at Citigroup. Follow him on Twitter @npclements.