It’s probably that at a 10% cap, the rate of default and the sale of defaulted debt amongst the riskiest lenders yield a negative rate of return, or at least one that doesn’t sufficiently exceed the risk free rate of return to be worth the hassle and risk compared to other investments. Alternatively, those with the lowest credit scores might simply see very low credit limits, like $250 limits or less to compensate for the risk and cap. Basically, if the companies could make the same money through safer investments, like treasury bonds, or other safer investments, then they will. They look to earn a risk premium over current treasury rates, which are used as the risk free rate of return in their investment calculations.
In a simplified scenario, you could invest money in a pizza shop, let’s say $100k. If your expected return is 5%, that’s about what you could get through investment grade bonds for much less risk, so why risk it on one business doing well? You might look for a 10% or 15% return on your pizza investment to justify the risk.
Same thing with credit cards. The companies know what the expected rate of return is for each credit score band when factoring the rate of default and other business costs. And they set rates to achieve their earning targets to justify the risk versus investing their capital elsewhere.
That being said, I’ve often found credit cards to be predatory and usurious. At the same time, they can provide necessary flexibility when managed well, including with low income borrowers. But they definitely create a cycle of debt for many people. A better solution is financial assistance and education to help people escape cycles of debt. That and a better overall social safety net. But I won’t hold my breath.
It’s probably that at a 10% cap, the rate of default and the sale of defaulted debt amongst the riskiest lenders yield a negative rate of return, or at least one that doesn’t sufficiently exceed the risk free rate of return to be worth the hassle and risk compared to other investments. Alternatively, those with the lowest credit scores might simply see very low credit limits, like $250 limits or less to compensate for the risk and cap. Basically, if the companies could make the same money through safer investments, like treasury bonds, or other safer investments, then they will. They look to earn a risk premium over current treasury rates, which are used as the risk free rate of return in their investment calculations.
In a simplified scenario, you could invest money in a pizza shop, let’s say $100k. If your expected return is 5%, that’s about what you could get through investment grade bonds for much less risk, so why risk it on one business doing well? You might look for a 10% or 15% return on your pizza investment to justify the risk.
Same thing with credit cards. The companies know what the expected rate of return is for each credit score band when factoring the rate of default and other business costs. And they set rates to achieve their earning targets to justify the risk versus investing their capital elsewhere.
That being said, I’ve often found credit cards to be predatory and usurious. At the same time, they can provide necessary flexibility when managed well, including with low income borrowers. But they definitely create a cycle of debt for many people. A better solution is financial assistance and education to help people escape cycles of debt. That and a better overall social safety net. But I won’t hold my breath.