Public discussion of the new credit card legislation makes clear that many people have not thought through the economic functions of this most ubiquitous form of modern consumer debt.
Nearly all U.S. adults have a credit card and many of us have more than one. They play a major role in the nation’s payments system and personal debt. Some 700 million cards are active and, according to the Federal Reserve, households owe $963 billion in credit card debt.
But not all card holders have them for identical purposes and not all pay the same price for the credit and payment services a card affords.
The stereotypical credit-card holder carries significant balances month to month, often pays no more than the minimum and occasionally pays late. They pay an annual fee, interest rates of 19 percent or more and summary penalties. This may, in fact, be the most common situation in real life.
But there are others. I have a friend with one card who uses it only for online purchases or travel reservations. He never carries a balance and makes all other payments with cash, check or online banking. Another acquaintance charges every possible purchase since she likes detailed monthly spending records on one statement and wants the frequent flier miles earned by her no-fee card. She pays off her balance nearly every month. A third has $15,000 of credit card debt taken on a “cash advance at 2.99 percent for the life of the loan” teaser offer. She used it for a remodeling project, since the interest was lower than home-equity loans.
These examples illustrate the range of economic functions that credit cards have. Some fall into the category of a “medium of exchange,” one of the traditional functions of money where cards have an edge in convenience or recordkeeping. Cards also serve as an option to meet unexpected contingencies.
Most importantly, cards function as a source of loans. Some are rational and strategic, like exploiting a teaser-rate balance transfer offer as a substitute for a home-equity loan. Some are desperate, one step higher than a pawn shop or a payday loan. Millions of accounts fall somewhere in between.
These functions, means of payment, loans and contingency insurance, are of value to households. But they have to be paid for somehow.
Credit-card lenders have three sources of income from issuing cards. They get fees from merchants who accept payment by card. They charge interest on outstanding balances. And they charge annual fees, penalties on late payments and fees for balance transfers and other optional services.
As with all lending, the credit-card issuer wants to gain as many customers and lend as much money as possible without incurring excessive losses on unpaid accounts. Household borrowers are not all the same. Success in credit-card lending involves offering slightly different products at different prices to different customers.
Competitive pressures are such that most issuers exploit asymmetric information in securing customers. If a customer does not fully understand the full cost of credit, the real interest rate or all the possible fees that may be charged, they are more likely to buy the product than if they really get all the details.
Free-market enthusiasts argue that credit cards are a willing agreement between autonomous individuals. Beyond requiring disclosure of terms, government should not play a role.
Government-as-protector advocates see market failure due to imperfect information and monopoly power. Government should regulate all aspects of such credit, including fees and interest rates, to protect the public from abuse.
The recent legislation falls toward the protection end of the scale. It bans certain fees or contingent interest rate increases deemed exploitive. But it does not regulate interest rates or fee levels themselves.
Advocates argue it will save consumers millions in fees and interest that will come out of the profits of issuers. Critics counter that issuers will have to raise general interest rates and annual fees to make up for now-banned charges. Furthermore, they argue, many marginal borrowers will not be profitable under the new rules and will simply be cut off from this credit, leaving them only harsher alternatives like payday loans.
Both sides are right. A recent story in the Financial Times estimated that the new rules will cost JP Morgan Chase’s credit card operations hundreds of millions.
It seems clear that no-annual fee cards will become rarer and that annual fees will rise. Credit card issuers don’t earn a great deal on people like my first two friends who seldom pay interest. There is a lot of evidence that such customers long were cross-subsidized by those paying higher rates or fees, perhaps in the hope that their punctual payment habits would erode over time and they would eventually pay more. Less money will be available for such cross-subsidization under the new rules.
The low-interest balance-transfer teasers have already shrunk in a tighter credit market and may disappear entirely.
The degree to which people with poor credit will simply see their access to credit cards disappear is unknown. Moreover, the effects of this legislation will be hard to separate from general industry retraction in the face of rising losses on existing accounts. But while credit cards will remain available to most households, they may not be as universal as they have been over the past boom decade.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.