Why are credit card interest rates so high?

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If you own a credit card,  you know how outrageously high are the interest rates charged on it. Even though credit cards are similar to personal loans – both are unsecured loans – the interest on the former is much higher compared to any personal loan.

The fact that credit cards make it possible for you to not only use extra funds but also receive reward points makes it a very popular financial tool.

Financing spends through credit cards is free, as long as the entire outstanding credit card bill is repaid by the due date. Finance charges of 24-49% p.a. are levied only on unpaid credit card bills and ATM cash withdrawals made through credit cards.

What is the reason for such high-interest rates?

Now the reason for charging high-interest rates on this product isn’t mere profit-making. The reason resides in the way credit is designed and the risk surrounding it due to its unpredictable nature of usage.

“The unsecured nature of credit cards makes issuers charge high interests due to the higher credit risk involved. However, a more important reason is the credit line sanctioned in the form of a credit card limit. Unlike personal loans, credit card users do not have to submit applications for accessing instant credit. All they need to do is swipe their credit card or use it online and repay the transactions as per their repayment capacity,” Sahil Arora, director of Paisabazaar.com said.

The freedom provided to credit cardholders in accessing the sanctioned credit limit increases the credit risk for card issuers. This is usually compensated by charging higher interest rates.

Meanwhile, the eligibility criteria for issuing a credit card are much easier than that of a personal loan. Along with this, credit card holders have the complete freedom to use the allotted credit as and when they want. The card issuer will not know from before as to how the card owner will use the credit amount, where will it be spent and when will it be repaid. All of this adds to the uncertainty and risk which is negligible for personal loans.

Now, the interest rates charged for loans against credit card and EMI conversions are much lower than the finance charges on unpaid credit card dues. However, the interest rates on these payment options too have been usually found to be higher than the personal loan rates offered by the same lender to the same cardholder.

Does a good credit score help in reducing interest rates?

Finance charges levied on credit cards by the card issuers are the same for all cardholders irrespective of their credit score, job profile, monthly income, or facets of their credit profile.

“However, the interest rate charged on loan against credit card and credit card EMI conversions can vary depending on the credit profile of the cardholders,” Arora asserted.

Will interest rates on credit cards reduce in the future?

According to Arora, changes in the interest rate regime have not impacted the finance charges levied on unpaid credit card bills.

However, lenders may factor in the changes in the broader market interest rates while setting the interest rates of EMI conversions and loans against credit cards for their cardholders.