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Question about interest
xraydog
Registered User regular
Registered User regular
I've come to the conclusion I don't know how interest works.
Why does my credit card have a 13% interest rate while my checking account only pays 0.8%? Why do I have to pay way more to use the bank's money but the bank doesn't pay shit to use mine?
Why does my credit card have a 13% interest rate while my checking account only pays 0.8%? Why do I have to pay way more to use the bank's money but the bank doesn't pay shit to use mine?
xraydog on
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So long as you pay your bill on time every month, you make the money and they don't. Well, off you anyways, they still make money off you buying stuff from a transaction fee.
Because a bank is a better credit risk than you are.
The bank takes most of your money and loans it to other people. those people pay more than .8%. That's how the bank makes money. The riskier a loan, the higher the interest rate. If someone wanted a small loan to finance part of a valuable item, and granted a security interest in that item, the bank will charge a low interest rate - 5%, let's say - because its chance of a total loss is low (it can take the thing purchased if the borrower defaults.
Your credit card is a loan-on-demand essentially, to buy whatever you want, with no rights for the bank to take what you buy. If you buy a TV on your Visa and don't pay for it, Visa can't take your TV back without a lot of hassle (read: legal expense and time). You've been given a magic pass to buy whatever you want. If you don't pay in full every month, the risk that you default, and the bank gets screwed, is very high (see also: the economy).
slighty longer answer: The chances of you not paying your credit card bill greatly exceeds the chances of the bank not having the cash to fund your checks.
Risk:
Jon and Bill have separate loans, each for 1,000. Jon pays on time every month. Bill is often late, and although he ends up paying eventually, he's had to pay some late fees and the bank has had to call him to remind him to send his payment.
Both go to the bank, separately, to ask for another 1,000 loan. The bank gives Jon a lower interest rate than Bill. Bill complains, but we see based on the history above that the bank has a good reason to see Bill as a riskier borrower.
Time:
Sarah buys a CD with a 2% interest rate; it lasts for 6 months, and at the end she buys another 6 month CD for 2%. Chloe buys a CD with a 3% interest rate that lasts for 12 months. Chloe gets a better interest rate because she's willing to lend her money for 12 months at the start, which gives the bank more time to use the funds before returning it with interest.
Amount:
This is pretty simple. You ask me for a hundred bucks, and you'll pay me back in a month. I say "Sure, no problem." Next year, you say "Eggy, I need to borrow $2000. I'll pay you back in a month and I'll give you an extra hundred." I say "I could use the money for something else, but since you need it and you're giving me an extra hundred, sure thing." The more money you ask for, the higher the risk -- which is why things like cars and houses are typically owned by the bank, rather than by the individual, because the property is collateral.
So what does this all mean for credit cards and your checking account? First, your checking account. You need to keep money in a bank nowadays, so the bank has no reason to give you interest. You're just storing your money there, and the bank can't really use it for anything because it's entirely liquid. You could go tomorrow and take out all of your money and the bank can't do shit about it. Which is good. But you're not giving them any reason to give you any interest on your money. They're doing you a service, but to keep you happy they're offering you a little interest.
Second, the credit card. When you purchase something with a credit card, you have a grace period before your balance is due. When the merchant accepts your credit card, they contact the card company and say "Xraydog just bought some pants for $75, please reimburse us" and the card company sends over $75. They're down $75, but at the end of the month they send you a bill and since you're a good customer they expect you to pay them on time, so they don't charge you interest.
If you neglect to pay them, they're still out the $75 bucks. Because they really don't want to be out that money with no guarantee for when you'll actually pay them back, they use a high interest rate.
Credit card companies do not make the majority of their revenue from interest; they make it from fees. When you use a credit card, they charge the merchant between 2-9% of the transaction (I believe -- some single digit number) and that's where they make their money. It's a convenience charge. The high interest rate on the backend? That's to tell you "Paying us interest is a BAD IDEA. See how high that rate is? That's REALLY high. So, seriously, pay us back on time, and we won't charge you any interest."
Ah, you got me excited there. I also use b of a for checking, though if I have money left over at the end of the month I put it in my SmartyPig account, which gets like 1.1%
Banks buy and sell money. Just like any retailer, they buy their product for less then they sell it for.
In this case your bank is buying your money from you (and others) for 0.08% monthly, and selling it "back to you" for 13%.
the difference is profit for the bank.
This isn't exactly true. Banks are only required to keep a certain percent of their holdings on hand at any given time. Under normal circumstances this is fine because they have enough on hand to pay out whatever small withdrawals are made each day. But this is exactly why a run on the bank can cause problems. If too large an amount is requested for withdrawal all at once, the bank won't be able to cover it.
The chart on that wikipedia page pretty much sums up why I think this is a terrible idea. An initial input of $100 into the system can lead to several hundred essentially imaginary dollars being created.
Google "FDIC."
In my experience, this is pretty much all you need to know about anything when it comes to other people/organizations and your money. Always make sure you know and understand the terms of what you sign, stay on top of your shit, and don't get behind on payments. If you think you might need to get behind for some reason, know the implications of doing so. That 13% interest rate could skyrocket, doubling or more, if you pay your bill three seconds late, and there will be basically nothing you can do about it.
Why? Because fuck you, that's why.
Yes, I understand the FDIC insures deposits up to 250,000. That just means a run on the bank is harder to cause a bank failure, not that it's impossible. Considering that WaMu was shut down for a period of time in 2008 (when the FDIC insurance covered up to 100,000) due to massive withdrawals and now no longer exists because of that, it's not outside the realm of possibility for it to happen even with the FDIC.
Besides which, my main point was that the bank isn't just holding your money waiting until you want it. Depositing that money allows them to make other loans elsewhere, with only the requirement that they keep a certain percentage of it on hand. So they are benefiting from the deposit. Saying that the bank can't use your money for anything is incorrect. It makes it less obvious why they pay such small interest on deposits, since those deposits are directly leading to increased funds available for lending by the bank.