Do Credit Cards Need Interest Rate Caps?

Article excerpt

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. …