The economics of credit card debt

By Felix Salmon
December 1, 2009

You’re a bank, and one of your customers owes you $2,000 on her credit card. You have two choices:

(a) You cut off her credit, convert the $2,000 to a loan, and she pays it off with 6% interest over four years.

(b) You keep the credit card open, she struggles to pay back the balance at 30%, and eventually declares bankruptcy with a principal balance of $1,205 outstanding, which you never collect a penny on.

Which of the two options do you choose? Mike Konczal has run the numbers, and it turns out that option (b) — driving the poor customer into bankruptcy — is actually more the more profitable of the two.

What’s more, the option value of option (b) is enormous: if she doesn’t declare bankruptcy you can make more money still, and of course if she keeps on spending on her credit card, that’s even more debt on which you can make predatory and usurious profits.

This is a prime example of what Ronald Mann calls the “sweat box” of credit card debt:

Debt-based issuers focus on debt servicing revenues… the most profitable customers are sometimes the least likely to ever repay their debts in full…

As the credit card borrower spirals downward, with the monthly balances growing to amounts that equal, or even surpass, the borrower’s annual income, the issuer begins to earn large monthly profits on the relationship.

This syndrome, Konczal explains, is the reason why Jackie Ramos was encouraged by Bank of America to deny people the ability to convert their credit-card debt into an easier-to-repay loan. Just don’t expect the banks to ever admit as much.

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