From the CBA Data Desk: What’s In an APR? What Ogres, Onions, and Cake Can Teach Us About Credit Card Interest Rates.

Shrek: For your information, there's a lot more to ogres than people think.

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Donkey: They stink?

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Shrek: [peels an onion] NO! Layers. Onions have layers. Ogres have layers... You get it? We both have layers. 

Donkey: Oh, you both have LAYERS. Oh. You know, not everybody likes onions. CAKE! Everybody loves cake! Cakes have layers!

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Whether it’s ogres, onions, or cakes, breaking credit card annual percentage rates (APRs) into layers can help us understand this core component of credit cards better. As a financial tool millions of Americans utilize each day, credit cards offer flexibility, convenience, and liquidity when they are needed most. APRs are vital to maintaining the viability of credit cards and understanding the components of APRs helps to clarify their role and importance. In this edition of the CBA Data Desk blog, we’ll use the layers of Donkey’s cake to break down and simplify the different components that are baked into credit card APRs.^[i] Much like the titular character of Shrek—our cake is layered.

Key Takeaways

An APR is a pricing mechanism that must account for multiple components including:

• Pricing for the Cost of Funds. The cost to obtain and hold the funds a bank uses to lend to consumers in the form of credit. 

• Pricing for Expected Losses. The amount of money a bank lends that it expects may not get paid back.

• Making a Return on Investment. Profits that allow companies to remain solvent in economic downturns and reinvest in new products and features. 

As we explain in the blog below, each of these layers plays a crucial role in creating an accessible, innovative, and financially sound credit card market.

Layer 1: Pricing for Cost of Funds

To lend to consumers, banks first have to acquire the funds to do so. One of the most well-known sources of funds are customer deposits. These are the checking, savings and other accounts customers place at their bank. Other sources of funding can include larger deposits from other banks or large companies that are acquired through brokers (sometimes called “wholesale” and “brokered” deposits), funds borrowed from other banks, funds borrowed from the Federal Home Loan Banks (FHLBs), and funds borrowed from the Federal Reserve.

Acquiring these funds to make loans is not free. Just like consumers pay interest on the funds they borrow, banks also have to pay for the funds they acquire to make loans. For banks, this is the interest paid to consumers on the deposits they hold at the bank as well as interest they pay to the institutions, brokers, other banks, and the central bank they borrowed from.

(Figure 1)

All of these costs are combined to give us the overall “cost of funds” for a bank—commonly represented as the ratio of interest paid on funds borrowed divided by the total amount of deposits and other funds a bank borrows.^[ii] Data from the 2024 show that credit card banks’ cost of funds is more than twice as high than that of non-credit card banks (Figure 1).^[iii] A primary reason their cost of funds are higher is because credit card banks typically lack large branch networks that attract lower-cost “core” deposits, causing them to rely more heavily on higher-cost wholesale deposit funds compared to their non-credit card specializing peers.

This higher cost must be accounted for in the price of the credit that is being given to consumers. Accordingly, the APR will reflect the cost of the funds used by the bank to fund a customer’s credit card borrowing. 

Layer 2: Pricing for Operating Costs

APRs must price in the operating costs it takes to run a credit card program at a bank. Credit cards have been found to incur larger non-financial costs than other forms of lending. Research from the Federal Reserve found that “due to their intensely retail orientation, credit card operations have especially large operating expenses: 4-5% of balances annually.”^[iv] These operating expenses can include the costs of:

• maintaining the technology stack required for increasingly complex card operations; 
• staffing to design, market, and maintain innovative products;
• compliance and regulatory monitoring;
• specialized staffing to monitor and manage credit risk while expanding credit access; and
• maintaining a retail-facing operation to support robust customer service.

For larger banks who focus on credit cards for their business, these costs comprise a significant portion of the non-interest expense as credit card issuers work to compete vigorously to maintain market share, minimize losses, expand access, and innovate. In a market with over 4,000 issuers, and where consumers on average hold roughly four credit cards in their wallet (not to mention their other forms of payment), maintaining relevance and best-in-class products and service is key. It is not enough to have a consumer sign up for a card; banks also must ensure they stay “top of wallet.” The same Federal Reserve research found that overall operating costs, particularly marketing expenses, encompass a large proportion of default-adjusted APR spreads.^[v] Just like any business or product, all of these operating costs must be covered in the price at a minimum to ensure a viable business. 

Layer 3: Pricing for Expected Losses 

Expected Losses (Charge- Offs)

Lending money involves risk. One of the largest being that the customer a bank lent money to will not pay those funds back. Banks try to estimate and project these losses in several ways to ensure they are lending prudently and making a return on their investment. While the methods banks use to estimate losses can vary, a simple way to understand expected losses is to look at past losses in the form of charge-offs. 

Charge-offs represent balances on credit cards that are deemed to not be recoverable by the bank as the borrower has not made any payments on their card for an extended period (typically 120 to 180 days; 4 to 6 months). For the purpose of pricing, if banks see or expect an increase in charge-offs, it indicates an increase in the number of customers not paying back the money they have borrowed on their credit cards.

(Figure 2)

Data show that this risk has been increasing and is higher than other forms of credit. In the first quarter of 2025, charge-offs on credit cards totaled $16.41 billion.^[vi] On average, 53 percent of banks’ default losses are from credit card lending.^[vii] Likewise, the charge-off rate for credit cards at all banks was 5.88 percent in 2025 Q1. That’s three times the rate for auto loans (1.86 percent), well over 500 times the rate for mortgages (0.01 percent), 60 times the rate for HELOCs (0.10 percent) and nearly three times the rate for other individual loans (2.01 percent; Figure 2).^[viii] These charge-off risks are what banks must account for to follow prudent risk-based pricing practices. 

Risk Premiums to Account for Expected Losses

As noted above, the risk of losses is especially higher for credit cards compared to other consumer loans. Unlike other forms of lending that are secured (such as a mortgages or auto loans) and have an underlying asset like a house or a car that the bank can take possession of and sell to recoup some of the money it provided, credit cards are unsecured and do not offer this type of backstop, meaning banks are less likely to recover the funds borrowed. 

Credit card borrowing is also variable. Instead of a fixed amount being repaid over a fixed timeline like a car loan of $7,000 paid over 7 years, credit card borrowers have an amount they can borrow up to and repay in multiple ways, whether it be all at once or over time. While this provides valuable flexibility for consumers, it also adds uncertainty for a bank. Banks have to try and predict how much a customer will borrow in a given month on their credit line and how much will be paid back while also considering the potential risk that a customer may simply continue to maintain a balance and never pay it back at all. 

All of these risks are hard to know when someone applies for a credit card. Even credit scores cannot fully predict every situation with 100% accuracy. Yet, banks are still charged with managing this uncertainty and pricing the risks associated with it accordingly.

To do this, banks price in a premium that accounts for the future possibility that a borrower may not repay their loan—or “default”. The amount of this “default premium” increases either as the borrower risk or product risk increases. As credit cards represent one of the riskiest forms of lending, and banks have expanded access to this form of lending, these premiums tend to be higher for credit cards, constituting a higher APR. 

The additional interest income gained from a higher APR is designed to offset some of the increased risk a bank takes when providing credit in the form of a credit card. This first layer of an APR is often the most visible and pronounced, with multiple reporting agencies tracking delinquency and charge-off rates at various banks every month to measure how consumers are handling their balances as well as how banks are managing and pricing the risk in their credit card portfolios.

This risk premium component to APRs also helps banks, particularly those with large credit card businesses, guard against increased losses during an economic downturn—similar to a “rainy day fund”. Charging a premium on higher risk loans like credit cards through higher APRs helps ensure a bank has ample reserves to manage through a crisis when losses on these loans start to increase. 

Layer 4: Pricing for Unexpected Losses

As noted, credit card lending presents different and at times greater risk than many other forms of lending. Accordingly, it garners significant federal oversight not only from consumer financial regulators, but prudential regulators as well. Prudential regulators pay close attention to banks’ capital and risk management practices to assess their ability to withstand increased losses on their credit card portfolios. This means banks must hold more capital reserves against their credit card exposures including not just card balances outstanding, but a portion of the credit lines they offered to customers to demonstrate they can remain solvent if card usage and delinquency rates increase. This additional capital banks must hold against credit card exposure has a cost that must be accounted for.

(Figure 3)

Data from the Dodd-Frank Act stress tests (DFAST) for some of the largest issuers shows projected losses increasing as credit card balances and risk rise—directly impacting the reserves banks must hold and ultimately the capital (cost) to a bank (Figure 3). Results from the most recent stress tests showed that, under the Fed’s severely adverse scenario, credit card losses alone account for $157 billion or 28 percent of total projected losses.^[ix] As issuers provide greater access to credit to more borrowers, risk (measured by projected losses) in credit card portfolios increases. This also increases the amount of capital issuers have to hold, increasing their costs, which then flows through to the APR on credit cards.

Layer 5: Regulatory Pricing Constraints 

Under normal risk-based pricing practices, if a consumer exhibits increased risk, such as through a rise in late payments, borrowing above and beyond their established limit, or even a failure to make a payment altogether, an issuer would need to account for this increased risk, likely through increasing the price the consumer pays for credit through the APR. However, in 2009 Congress passed a law, the Credit Card Accountability Responsibility and Disclosure Act (the “CARD Act”), which set a range of new requirements for the industry. In doing so, Congress made it very difficult to reprice credit card balances, even when a consumer has shown increasing signs of risk of non-repayment.

While these changes were aimed at protecting consumers from increased costs, they have also altered how issuers can account for rising risks through pricing.  

Specifically, the CARD Act generally prohibits banks from repricing consumers’ credit card APR’s upward unless it is tied to an increase in an underlying indexed rate (such as the Fed Funds rate). It also lays out a “delinquency exception” in which issuers could increase rates when a consumer does not pay at least the minimum periodic payment within 60 days after it is due.^[x]

This not only increases program costs but also does not fundamentally address the underlying increase in risk that the consumer has shown. Ultimately, these additional repricing restrictions make it economically and operationally too challenging to increase rates after the original approval. 

This means issuers effectively get one shot to adequately price a consumer’s credit for the entirety of the time they will have their credit card. To account for the future risks a customer may present, but that they can no longer reprice for, issuers must account for it in the initial APR. This helps offset the reduced flexibility in repricing and addresses the additional potential risk. 

Put simply, when setting an APR on a credit card, an issuer has to account not just for near-term default risk, but default risks from the consumer almost indefinitely.

Additionally, an issuer has to account for future changes in the economy that may increase the costs of the original amount a customer borrowed, but that the existing APR does not cover. In these cases, without the ability to reprice the APR in the future, issuers have to build in a margin to ensure that future market conditions will continue to be covered by the current APR.

The CARD Act and other proposals have also restricted pricing different risk events through fees. Caps and regulations on these fees do not remove the increased underlying risk posed by a consumer. Instead, they artificially shift how an issuer can price (and thus mitigate) it. This risk must now get priced into the initial APRs customers receive. Some advocates of these restrictions on fees have welcomed this as they see APRs as an easier pricing tool for consumers to understand. However, it also means APRs could increase for some consumers as issuers must account for a greater number of risks.

Layer 6: Making a Return on Investment and Building in Margin

The last piece of this layer cake—the “bottom line” or layer—is profit. On average, credit cards are more profitable than other types of loans. The Federal Reserve’s Report to Congress on the Profitability of Credit Card Operations of Depository Institutions shows that credit card banks’ return on assets (ROA) is higher than other commercial banks.^[xi] Return on assets for these banks has been relatively consistent since the last recession and is now slightly lower than pre-pandemic with ROA for credit card banks equal to 4.21 percent in 2019 and 3.33 percent in 2023. 

Some of these higher profits are to guard against economic downturns. Lenders price today with tomorrow’s downturn in mind and profit made today can add insulation and keep access to credit open when the economy turns downward. The same report to Congress on credit card profitability shows that provisions for loan losses are consistently higher for credit card banks than other commercial banks by a wide margin. Though performance on all loan types tends to decline in a recession or during high inflation, as the U.S. just experienced, credit card performance usually declines first and furthest. Issuer profits also allow for further investment in new product features like installment plans that help consumers pay down balances faster and alternative underwriting methods like cash flow underwriting that expand credit access. 

The Bottom Line 

Understanding credit card APRs requires looking at the component pieces they are comprised of. Banks must price in substantial and persistent risks—particularly the likelihood of losses from default, higher operating expenses, and the uncertainty inherent in unsecured, revolving credit. Add to this the regulatory constraints on pricing flexibility, growing reserve requirements, and the need to maintain competitive products in a saturated market, and what determines an APR becomes clearer. APRs reflect a complex layering of risk management, compliance, and operational demands. While credit cards do offer profitability, that profit is closely tied to the risks and costs banks bear in providing accessible, unsecured credit. Whether you prefer onions, cakes, or ogres for your analogy, the takeaway remains the same: APRs are an important and well-balanced pricing tool that keeps credit accessible, innovative, and prudent.

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^[i] While the author has an affinity for onions, especially in his Sunday sauce, cake seems more appealing and less smelly than onions as an analogy. 

^[ii] Cost of Funds represented as total interest expense as a percent of the sum of average interest-bearing liabilities and average noninterest bearing deposits.

^[iii] Credit card banks are banks with average assets greater than or equal to $200 million, with a minimum 50 percent of assets in consumer lending and 90 percent of consumer lending in the form of revolving credit. Source: Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Reports).

^[iv] Drechsler, Itamar and Jung, Hyeyoon and Peng, Weiyu and Supera, Dominik and Zhou, Guanyu, Credit Card Banking (March 01, 2025). FRB of New York Staff Report No. 1143, https://doi.org/10.59576/sr.1143, Available at SSRN: https://ssrn.com/abstract=5169910 or http://dx.doi.org/10.2139/ssrn.5169910

^[v] Ibid; see also CFPB 2023 Consumer Credit Card Market Report at p.74 “In 2022, credit card marketing efforts were at their highest since at least 2015. Monthly mail volume reached 610.6 million items in September 2022…”

^[vi] FFIEC Call Report—All Banks

^[vii] https://libertystreeteconomics.newyorkfed.org/2025/03/why-are-credit-card-rates-so-high/

^[viii] Supra note 1

^[ix] Dodd-Frank Act Stress Test 2024: Supervisory Stress Test Results June – 2025, Figure 9. Retrieved from https://www.federalreserve.gov/publications/2025-june-dodd-frank-act-stress-test-results.htm

^[x] 12 CFR 1026.55(b)(4). The process mandates: Outreach to consumers to inform them of the increase (and potential future decrease); and Additional monitoring and a subsequent decrease in rate if the consumer completes six timely minimum payments; or A periodic review based on certain factors to reduce the APR applicable to the consumer’s account, as appropriate

^[xi] Credit card banks are defined by two criteria: (1) More than 50 percent of their assets are loans to individuals (consumer lending), and (2) 90 percent or more of their consumer lending involves credit cards or related plans