How Do Banks Insure Against Unsecured Credit Card Losses?

Screening

Banks do not give unsecured credit cards to everyone. Before obtaining a card you must submit a credit application and as part of that application process you consent for the card issuer to check your credit report. Banks believe that your past credit history gives an insight into your probable future credit management. If you have always paid your bills late then you are likely to continue while people who have good credit are likely to maintain their good credit. Obviously, job losses and cash windfalls can change things, but banks only issue unsecured credit cards to people who seem likely to repay the debt.

To issue credit cards, banks have to first borrow money from other banks or depositors. Banks pay a low rate to borrow this money and the most creditworthy customers can borrow this money form the bank at the bank's prime rate. This rate always remains at 3 percent above the cost of inter-bank borrowing. Banks use prime rate to price home loans and car loans, but credit cards are set at a margin above prime rate. Depending on your credit score, banks often price your card at a margin of between 5 percent and 30 percent above prime rate. Either way, your bank makes a huge profit on borrowing money and then lending it to you.

Despite the bank's attempts to limit credit cards to only the most creditworthy borrowers, some people inevitably fall on hard times and default on their debts. Banks can lose huge sums of money when borrowers default. However, banks offset their losses by charging higher interest rates to other borrowers. If one borrower defaults on a $1,000 debt, the bank breaks even if four other borrowers keep making interest only payments on $1,000 credit cards with interest rates of 25 percent or more. In reality, for every one card that goes into default, the banks have thousands of other cardholders who continue to pay interest and more that offset the loss.

During severe recessions banks incur higher than normal losses on credit cards. To offset these losses, banks charge annual fees and sell other card-related services, such as credit monitoring services to raise more fee income. In a worse case scenario, a bank faced with heavy losses could turn an unsecured credit card into a secured debt. Laws in many states enable creditors to place liens on residential property to force the repayment of debts. This rarely happens, but the fact that it could, provides some peace of mind to the credit card companies during tough economic times.