A reader asks:
Why is capping credit card rates a bad idea? What other ways can we make rates less insane?
President Trump recently floated an idea to cap credit card rates at 10%.
At first glance this seems like a good idea.
Credit card rates for most borrowers are between 20 and 30%. The average balance for the approximately 45% of people who don’t pay off their balance every month is around $6-7,000. Carrying a balance while paying the high interest rates is a sure way to crush your finances and credit score.
So why would capping these rates be a bad idea?
JP Morgan CFO Jeremy Barnum explains it like this:
We are convinced that these types of actions will have exactly the opposite effect of what the government wants for consumers. Instead of lowering the price of credit, we will simply reduce the supply of credit, and that will be bad for everyone: consumers, the broader economy, and yes, at the margin, for us.
Limiting interest rates would actually lead to banks reducing their lending in this area. Only those with solid credit scores would be able to borrow. Those who rely on credit cards to finance their lifestyles would be forced to take out personal loans or other more onerous borrowing programs.
I don’t think capping credit card rates at 10% makes sense, but I also don’t think the current system is fair to those trapped in debt that will backfire on you faster than the best investors in the world. I never understood why credit card rates always stayed high even though other interest rates were so low for much of the 2010s and early 2020s.
To understand why credit card rates are so high and how we got to this point, it’s worth reviewing a brief history of credit cards with some help from Joe Nocera in his book A piece of the action, which describes the growth of consumerism in the second half of the 20th century.
The first boom in consumer credit took place during the roaring twenties. The freewheeling attitude of that era was hastily eradicated by the Great Depression, which turned an entire generation of people into frugal misers.
It wasn’t until the aftermath of World War II that people wanted to spend money again, when everyone wanted to borrow money to finance their middle-class lifestyle. People wanted to buy refrigerators, televisions, new houses and the latest car model. And they didn’t want to wait.
Most banks were not equipped to deal with this new consumer. There was no real differentiation in consumer financial institutions at the time. No one paid interest on checking accounts and the rates for passbooks on savings accounts were regulated by law. Most people simply chose the nearest bank closest to their home or work.
Most banks focused more on business loans than on consumers. In fact, banks have been reluctant to provide consumer credit because they wanted to protect households from the dangers of borrowing too much money.
Bank of America was the first financial institution to recognize the growing importance of consumers in the new economy. After witnessing tremendous growth in installment loans, they began testing the BankAmericard in the late 1950s.
In 1958, Bank of America sent 60,000 credit cards to households in Fresno, CA. Nobody asked for it. They have just arrived in the mailbox. In 1959 there were 2 million cards in circulation and the race could begin. Chase and American Express were right behind them with their own offers.
So how did they set the interest rates on these cards so high?
Joseph Williams was the architect of BankAmericard. Williams determined credit card interest rates by studying how companies like Sears determine their interest rates. Nocera explains:
Williams had friends at Sears and Mobil Oil, and those friends let his team secretly observe their credit operations. This latest research, incidentally, resulted in a number of standard features of credit cards, features that have remained remarkably unchanged to this day. That study suggested the idea of a one-month grace period, a period in which customers could pay off their balances without incurring interest charges, as did the idea of charging 18 percent per year on credit card loans—a figure that would seemingly be set in stone over the next thirty years, even as every other form of interest rate fluctuated wildly. There was no black magic involved: the bank simply assumed that if a one-month grace period and a monthly interest charge of one and a half percent (which amounts to 18 percent per year) was good enough for Sears, with fifty years of credit experience, it was also good enough for Bank of America.
They also needed to get merchants on board to facilitate these new transactions.
That was an easy sell.
The bank would act as a de facto back office for retailers, guaranteeing payment within a short period of time, collecting payments from customers and making the process simple and convenient for consumers to spend money. The initial discount was 6% of each transaction.
The initial rollout was a disaster.
The fraud was widespread. Too many people did not pay their balance on time. Fifteen months later, Bank of America had lost more than $20 million, a significant amount at the time.
One of the reasons why the high rates stuck after the rollout period is that far fewer people paid off their balances each month than expected. The late payment rate was over 20% (they estimated it would be 4%).
So they cleaned things up, dropped users who didn’t pay, added some fines to the process, and strengthened fraud prevention. By the late 1960s, credit cards were a new profit center for the bank.
The use of consumer credit exploded, from just $2.6 billion in 1945 to $45 billion in 1960 and $105 billion in 1970.1
The rest is history.
We now have over $1.2 trillion in credit card debt in America:
Credit card rewards are a business in themselves, with people who pay off their balances every month essentially being subsidized by those who don’t.
Last year alone, American Express Delta paid more than $8 billion for its credit card/miles rewards partnership.
So the biggest reason credit cards have such high rates and fees is because we’ve always done things this way. This is not the system you would design if you were starting from scratch today.
How do you help people struggling with the burden of credit card debt?
Financial education would help.
Right or wrong, the best way to lower credit card rates is probably through stricter credit standards. These loans are not backed by anything, which is another reason why rates are so high.
I don’t know if there is a system-wide solution that you can wave a magic wand at to solve this.
If you have credit card debt, don’t rely on the government to take care of it for you.
Negotiate with the credit card companies if you cannot repay the loans. You can also try to negotiate the ridiculously high late fees. Or you can consolidate to a lower rate.
But keeping a balance sheet is one of the worst financial decisions you can make. The rates are so high that there is a negative compounding effect.
Barry Ritholtz joined me this week on Ask the Compound to address this question in detail:
We also answered questions about stock market valuations, 401,000 euro contributions, the best sources of financial information and buying versus renting.
Further reading:
How bad is credit card usage in America?
1In the 1950s, Bank of America had a $60 million loan portfolio consisting almost exclusively of $200 refrigerator loans.
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