Do you carry credit card debt? Why Capital One is betting on it.

Americans have become increasingly reliant on their credit cards since the pandemic. So much so that Capital One is willing to bet more than $30 billion that they won’t break the habit.

Capital One Financial announced Feb. 19 that it would buy Discover Financial Services for $35 billion. The combination could potentially shake up the payments industry, which is largely dominated by Visa and Mastercard.

For customers of the companies, it might eventually mean bigger perks and more merchant acceptance of Discover cards, and potentially lead to more competition in the payments industry. But most of the benefits will be going to the companies themselves, as well as the merchants who accept these cards.

Why is the deal important?

Some of the biggest issuers of credit cards are banks, like JPMorgan Chase and Citigroup. But Capital One and Discover are first and foremost credit card companies – like American Express, but with different clientele. They have tens of millions of customers and target their products at Americans who do not travel heavily outside the U.S. and would like to get more value out of their everyday purchases like gas, groceries, and domestic travel. In other words, people who typically don’t carry premium credit cards.

The combined company will have more loans to customers on its credit cards than JPMorgan and Citigroup combined. The merger also gives the Discover network the ability to fight on more equal footing with Mastercard and American Express in a way that it simply hasn’t been able to in its 40-year history.

“You want the customer or merchant to choose you as a company, either for your products or for your brand, and this deal gives them plenty of opportunity to make that case,” said Sanjay Sakhrani, a payments industry analyst with Keefe, Bruyette & Woods.

Who uses Capital One and Discover?

Capital One is one of the biggest credit card companies and banks in the country. It typically operates what is known in the credit card industry as a “barbell” business model – it issues credit cards to those with less-than-great credit as well as with super high credit, and little in between. The one group keeps a balance, bringing the company interest revenue, while the high-end customers spend heavily on their cards, bringing in fee revenue from merchants.

Discover’s customers are fewer but intensely loyal to the company. The company consistently wins customer service awards, and its cash-back cards are considered among the most lucrative in the industry.

But Discover suffers from a perception that because its payment network is smaller than Visa, Mastercard or AmEx, it is less desirable. Also, Discover is largely unavailable outside the U.S. as a payment option.

Capital One executives said Feb. 21 that they would start allowing customers to use the Discover payment network shortly after the deal closes, which could happen by the end of the year. Capital One also plans to keep the Discover brand along with its cards, although the cards could be co-branded.

What does this deal say about credit card spending?

This deal, at its core, is a big bet that Americans will keep running up their credit card balances.

Americans have been increasing their card balances quickly amid two years of high inflation. In the fourth quarter of 2023, Americans held $1.13 trillion on their credit cards, and aggregate household debt balances increased by $212 billion, up 1.2%, according to the latest data from the New York Federal Reserve.

Consumers are also paying higher interest rates on those balances. The average interest rate on a bank credit card is roughly 21.5%, the highest it’s been since the Federal Reserve started tracking the data in 1994.

Critics of Capital One have long said the company relies heavily on those who can least afford to be carrying high interest balances on their credit cards. Historically, Capital One has had higher default rates and higher 30-day delinquency rates than JPMorgan, Citi, Discover, and American Express.

What’s so valuable about Discover?

It’s virtually impossible to build a credit and debit card network from scratch in today’s market. Capital One executives described previous efforts to do so as a “chicken or egg” problem, where it’s hard to get merchants to sign up for a payment network when there are few customers, and vice versa.

Chicago-based Discover may be small but its infrastructure makes it poised to grow, particularly as more transactions move away from cash. The U.S. credit card industry is dominated by the Visa-Mastercard duopoly with AmEx being a distance third place and Discover an even more distant fourth place. Roughly $6.8 trillion is run on Visa’s credit and debit network compared to the only $550 billion on Discover’s network.

Owning Discover’s network would enable Capital One to get revenue from fees charged for every merchant transaction that runs on the network.

It also turns Capital One into the rare credit card company that controls the cards, the payment network, and the bank that issues the card. There’s only one other company that has accomplished this to scale: American Express.

Will regulators approve the deal?

It’s unclear whether the deal will pass regulatory scrutiny. Nearly every bank issues a credit card to customers but few companies are credit card companies first, and banks second. Both Discover – which was long ago the Sears Card – and Capital One started off as credit card companies that expanded into other financial offerings like checking and savings accounts.

Bank regulators have signaled for some time that they want to give more scrutiny to large mergers in the financial services sector. The combined Discover-Capital One company will have more than $600 billion in assets, making it bigger than most large regional banks in the country.

Consumer groups are expected to put heavy pressure on President Biden’s administration to make sure the deal is good for consumers as well as shareholders. Left-leaning politicians like Sen. Sherrod Brown, the powerful Democratic chair of the Senate Banking Committee, are already calling for close scrutiny of the deal.

“The deal also poses massive anti-trust concerns, given the vertical integration of Capital One’s credit card lending with Discover’s credit card network,” said Jesse Van Tol, president and CEO of the National Community Reinvestment Coalition.

This story was reported by The Associated Press.