Following President Bush's call this past fall for lower credit card interest rates, the Senate voted for an amendment that would cap these rates several percentage points, on average, below what is currently charged.
After the vote, the stock market plunged, panic selling rocked the $60 billion credit card securities market, and banks threatened to pull cards from as many as half of current cardholders if the amendment became law.
The Senate dropped the amendment, but calls to control these rates continue.
Are credit card interest rate caps in order? As we explain in the following article, any moves to do so would likely backfire--raising costs and curtailing availability of credit cards for consumers.
The credit card market is both competitive and diverse, offering consumers a variety of choices. Cards can be found with interest rates varying from 9.5% to 21%, differing annual fees and credit limits, varying grace periods, extended warranties, and purchase rebates. Government-mandated interest rate ceilings would disrupt this diverse market, ultimately leaving consumers with less choice among services and rate structures.
Credit card use has grown briskly over the past four years. At the end of 1990, more than 78 million people owned some 289.4 million Visa, MasterCard, American Express, and Discover bank cards, up from 198.7 million cards in 1986, a 46% increase. According to the Nilson Report, an industry newsletter, Americans charged $272.36 billion in 1990 on their Visas and MasterCards alone, generating $34.24 billion in revenue for the card issuers, of which $26 billion was interest payments.
This growth reflects consumers' desire for the bundle of services that credit cards provide. The credit card is easier to use than personal checks, and eliminates the security problems of carrying cash. For some people the credit card supplements savings accounts as a source of "rainy day" funds and represents a more convenient means of obtaining a consumer loan.
The expansion in the number of credit cards also has provided new credit opportunities for previously ineligible groups. Students, individuals without credit records, and people of modest incomes can now get cards. Credit cards benefit not only the "rich" or those people with proven credit records (who previously dominated the class of cardholders), but a broad cross section of society.
But some politicians would curtail the expansion of credit opportunity. Sen. Don Riegle (D-Mich.) says that card issuers sometimes "reach too far. In an effort to try to broaden their customer base, they sometimes offer a line of credit to a borrower who is not going to be able to repay it." In other words: stop giving cards to dead-beats and credit card interest rates could be lowered.
The problem with such suggestions is that, when a bank decides to offer credit cards to an untapped market, it does not know which individuals will become delinquent and which ones will repay. Hence, it issues cards to everyone who meets the eligibility standards based on a data mix of credit history, salary level, and other characteristics credit card issuers deem important. If government intervention mandated that banks stop giving credit to anybody who might be a credit risk, honest individuals who earn modest incomes and lack a credit history, such as young and lower-income consumers, could be denied credit cards.
More Than Interest
Advocates of nationwide interest-rate caps argue that such legislation will benefit cardholders by lowering finance charges, as if all cardholders should care about is the interest rate charged. But interest rates are only part of the picture; other fees, terms, and conditions in the credit agreement are also important.
For example, consider an individual who holds a bank card that charges a rate of 19.8% on outstanding balances, but pays back his outstanding balances within the no-interest grace period, usually about 25 days. Such an individual would be indifferent to the interest rate charged on the credit card because he does not pay any interest. But he would be concerned about other costs such as annual fees.
About 34% of all bank and retail card users are "convenience users," individuals who pay their debts within the grace period. These people would have to pay higher annual fees if interest rates were forced down. This is because credit card issuers tend to charge higher annual fees to offset lower interest rates: the lower the interest rate, the higher the annual fee.
Further, studies of the use of retail cards in California and Texas have determined that a majority of credit card users would be better off with a higher interest rate, because it allows them to pay lower annual fees. One study examined the value of customers of three different cards: a card with a 21% interest rate, no annual fee, and a grace period; a card issued with a 15% interest rate, no annual fee, and no grace period; and finally, a card issued with a 15.6% interest rate, a $10 annual fee, and a grace period.
It was found that 58% of the customers using the lowest-interest rate card would have saved money had they opted for the high-interest card. The middle-interest option cost 76% of its users more money than the high-interest card. While some users saved money on the lower-interest rate cards, the majority did not. The key lesson is that other characteristics of credit cards may be more important to consumers than the interest rates. If a consumer is looking for a card for routine use, the study recommends no-fee cards with a grace period, "and don't pay attention to the interest rates."
Arguments for capping rates ignore the fact that if interest rates are lowered, banks will raise other costs to cardholders. The table below demonstrates how a drop in interest rates that is offset by fee increases affects different cardholders.
Outstanding Annual Interest Finance Annual Balance Fee Rate Charge Payment $1,500 none 17.95% $269.25 $269.25 1,500 $48 13.95 209.25 257.25 1,200 none 17.95 215.40 215.40 1,200 $48 13.95 167.40 215.40 300 none 17.95 53.85 53.85 300 $48 13.95 41.85 89.85
In this hypothetical change in billing, those with an average $1,500 in revolving credit would-save $12 a year if rates were dropped four percentage points and fees increased to $48; those with just $300 in revolving credit would lose $36. Interest rate controls could, in effect, simulate a tax on low credit card balances.
Other costs can be imposed on card users in response to interest rate ceilings: the billing cycle used to calculate interest charges might be adjusted; grace periods could be shortened or eliminated; late fees could be increased and service fees per transaction imposed; and merchant discount fees, charged to retailers by card issuers, could also be increased. Consumers could then see both increased retailer costs passed along as higher prices, and face the inconvenience caused when fewer retailers accept their credit cards.
The individual who is likely to maintain outstanding balances has an incentive to shop around for cards with lower interest rates. The credit card industry offers a wide range of options for interest rates, annual fees, purchase rebates, credit limits, and grace periods. A bank in Elkhart, Indiana offers a credit card with a 12.9% interest rate. The trade-off in this case is a $20 annual fee and the lack of a grace period; interest accrues from the date of the transaction. Similar deals can be found in many localities.
Is the Market Competitive?
Those who advocate nationwide credit card interest controls assert that the credit card market is not competitive. However, as of December 1990, about 6,000 banks and other institutions compete in the credit card market.
The six largest credit card issuers account for only 30% of the credit card debt volume, and the second six largest register only 13% of total debt volume. These figures do not indicate a concentrated industry. Many local banks compete nationwide, issuing cards throughout the country. National financial and consumer publications frequently list bank card issuers with the lowest fees or interest rates.
Issuers of bank cards aggressively seek new customers for their cards. To protect market share, many have added services, such as merchandise discounts and extended warranties on products purchased with the cards. Some bank cards offer refunds on hotel rooms and discount car rentals. Others offer free flight insurance when a bank card is used to pay for airplane tickets.
Competition also comes from new card issuers. Sears directly challenged Visa, MasterCard, and American Express by launching the Discover Card in 1985, and now holds about 37.8 million accounts. In 1987, American Express offered selected customers the Optima credit card, which does not require full payment of balances due each month. And AT&T launched its Universal Visa card in 1990, and is now the largest nonbank Visa card issuer with seven million accounts to its credit. In order to market the cards, neither Discover nor the Universal Card charged an annual fee when starting up; in fact, the Discover card still has no annual fee and annually rebates cardholders up to 1% of their purchases.
Amidst this competition--and in contrast to claims by credit cap proponents--profitability of credit cards has been declining in recent years. In 1989 banks earned $20.51 per card, which fell nearly 10% to $18.41 the following year. For 1991, the Nilson Report expects profits to drop another 17% to $15.32 per card.
Rates Reflect Costs
One reason why listed credit card rates are higher than many other forms of consumer credit is that higher costs accompany credit card loans. Handling a single credit card account has been estimated to cost 10 to 12 times what it costs to handle a single consumer loan. This cost stems from risk, the number of credit extensions, and processing.
If someone takes out a car loan and fails to make car payments, the bank can repossess the car. It has no such recourse with credit card users; extensions of credit to the cardholder require no collateral. Because credit card applications are normally conducted through the mail, the lack of personal interviews compounds the risk factor.
Credit card purchases also differ from other forms of credit in that a credit card can be drawn on at any time, debt can be repaid on flexible terms at the discretion of the cardholder, and cards are issued to more diverse, risky groups than traditional loans. These factors add to the credit risk associated with credit card loans, and result in higher interest rates.
In addition, credit cards involve far more transactions than other forms of credit. Every time a credit card is used, the bank has to administer and record the transaction. A mortgage, in contrast, involves only one transaction per month. Also, because individual payments tend to be lower with credit cards than with mortgages, administrative costs will necessarily be a greater percentage of outstanding credit card balances.
And They're More Stable. Credit card interest rates have remained around 18% or 19% since 1978, while interest rates on other forms of credit have fluctuated greatly. From 1977 to 1981, while the prime rate rose from 8% to 20%, credit card rates remained between 18% or 19%. The recent spread between credit card interest rates and other interest rates also was the norm in the late 1970s. The 1980-82 period, in which other rates were close to or even exceeded credit card rates, is the anomaly; card issuers recorded losses during this period.
The price banks pay for borrowed money, called the "cost of funds" makes up 80% to 90% of the total costs of the typical car loan. For a credit card loan, the cost of funds is about 46% of total costs. Since credit card costs are less dependent on the cost of funds than other forms of credit, credit card interest rates are less responsive to changes in these costs. Therefore, one should not expect credit card rates to correlate closely with the prime rate.
Another reason for the relative inflexibility of credit card rates is the nature of the credit card market's expansion. In the early years of the market, many states had usury laws which capped credit card interest rates. Consequently, card issuers sought only high income individuals or long-term depositors because they were good credit risks. In 1978, the Supreme Court held that nationally chartered banks could lend money at the usury cap set by the state in which they are incorporated, regardless of the credit card cap in which the borrower resided.
As Christopher C. DeMuth wrote in the Yale Journal on Regulation: "This gave many bank card issuers the pricing flexibility they previously lacked, but commercial interest rates began to decline at about the same time, while the demand for credit cards apparently increased. The result was that credit card interest rates neither rose nor fell; instead, issuers greatly expanded the quantity of credit they made available to individual cardholders and solicited new accounts from groups such as college students, which were riskier and therefore costlier to serve than those who had received cards earlier."
Transaction costs also make cardholders less sensitive to changes in credit card interest rates: changing cards takes time, and new cards often require a fee. Lower interest rates often cannot compensate for these costs. For example, an individual with an $800 monthly balance who switches from a card charging 19% to one charging 16% would save only $2 per month in interest. Many individuals--especially those who are more interested in other card features, such as credit limits and grace periods--may have decided the switch is not worth the trouble.
In sum, the current fee structures in the credit card market are the result of millions of consumers making demands in the marketplace. They have demonstrated their preference for low fees in exchange for higher interest rates, and an increasingly competitive credit card industry has accommodated their demands. The market works. Government interference in the market will only make consumers worse off.…