Why do banks offer no annual fee credit cards?

One of the questions that people can have about no annual fee credit cards is why do banks offer the cards?  After all, the annual fee is a part of what makes a card profitable.

One of the most important things to remember about personal finance is that if a thing looks too good to be true, then it often is.  This means that a credit card can be rejected because a person does not understand how it works, and so thinks that it is too good to be true.  In fact there are good reasons to have a no annual fee credit card, and it is not too good to be true once the no annual fee credit card is understood.

The annual fee is only one component of the revenue of a credit card, and usually it is the smallest part.  The other two parts of what makes up the credit card’s profitability are the interest rates that are charged on borrowing and the merchant fees that are charged to shops and service providers in return for processing the credit card payments.

As annual fees are the smallest component in a credit card provider’s revenue, then it is not clear why they are being charged.  In fact an annual fee tends to cover the administrative expenses of the credit card.  The credit card companies can often cover the administrative expenses through slightly higher interest charges but there are two problems with this.  Firstly the interest rates could look larger than other cards that charge annual fees, when the cost is actually the same, and secondly this may encourage credit card users to apply for a large number of “free” credit cards that they barely use but cost just the same to run as a credit card which is used frequently.

The credit card companies do not need annual fees, and so it is perfectly possible to take the annual fee off the credit cards.  There are two ways in which this is done.  As merchant fees can not be practically increased then there may be higher interest rates on these cards.  However there are also ways to cut down the cost, such as reducing the extras that are put on credit cards such as free insurance.  Another way to cut costs is to have a higher credit score, so cutting down the defaults on the loans.