Why credit-card interest rates won’t be capped

By Felix Salmon
December 29, 2009
a feature, not a bug. But would it fall dramatically? Pamela Yip quotes Odysseas Papadimitriou:

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What happens if you cap credit-card interest rates at 16%? Yes, at the margin, the amount of credit extended on credit cards would fall. That’s a feature, not a bug. But would it fall dramatically? Pamela Yip quotes Odysseas Papadimitriou:

“If you cap the interest rate, it’s not like people are going to have lower interest rates than they do now,” said Odysseas Papadimitriou, chief executive and founder of Evolution Finance Inc., which operates CardHub.com. “Instead, everyone who has an interest rate below 16 percent will continue to have the same interest rate and everyone who has above 16 percent will not have access to credit any longer.”

Papadimitriou previously was senior marketing director at Capital One, so he has some insight into how card companies work.

This isn’t really true.

For one thing, credit-card companies make substantially all of their profits from people paying more than 16% interest on their cards. The rest of us generate a certain amount of cashflow in terms of interchange fees, but mainly we’re option value: so long as we have a credit card, there’s a chance that we’ll start running up large balances on it, miss a payments by a couple of days, and suddenly we’re a high-value customer.

Capping interest rates at 16% would force credit-card companies to move away from the current soak-the-poor sweatbox approach, and move instead towards a much more equitable system without bizarre cross-subsidies from the poor to the rich. Chances are that annual fees would rise and loyalty rewards would shrink — and as a result the people who pay off their cards in full every month — the people who use credit cards mainly for payments convenience, rather than because there’s a credit line attached — would start using credit cards less and debit cards more. Again, feature, not bug.

What’s not true is that anybody currently paying a rate of interest above 16% would suddenly find themselves with no credit at all. Mike Konczal, back in May, showed this mathematically: high credit-card interest rates are all about maximizing profit for the card issuer, rather than being remotely related to increased credit risk. If you’re currently paying 29.99% on your credit card, that’s not because it’s the minimum level at which you’re profitable for the bank: rather, it’s because it’s the level at which you’re maximally profitable for the bank. Big difference. There’s a very good chance the bank would make money charging you 16%, too — just not as much money.

That said, Yip is right that the cap on interest rates ain’t gonna happen. The banking lobby is too strong, and we’re up against serious reform fatigue in Congress. Instead, we’ll continue to live in a world where banks deliberately make it as hard as possible to borrow money the old-fashioned way, by taking out a loan, just because they make so much more money by offering you a credit card instead. And that’s depressing.

5 comments

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This doesn’t really explain why low-value customers are charged low interest rates and why high-value customers are charged high interest rates. It seems plausible to me that the people who pay high interest rates are the sorts who are less likely to shop around for good rates, or even that their is something of an oligopoly with an informal understanding that one doesn’t try to poach one’s competitors’ high-value customers. I’d like some kind of explanation, though, why people are paying substantially higher interest rates than is necessary for a credit card to make money off of them.

By the way, I missed a payment on my Capital One card recently, and they charged my a 50 cent finance charge. No late payment charge; just a nice understanding note and a clear emphasis that I should make my new minimum payment by the next date. If anyone reading this is thinking of getting a Capital One card, go for it, but try to make it known to them that you’re doing so because you heard they treated a customer well. It’s when credit cards think that treating customers well will lead to long-term profitability that they’re most likely to treat customers well.

Posted by dWj | Report as abusive

Credit radically changed in the late seventies when usury rates were overturned for most lenders. Then in the eighties (I think) technology enabled credit card issuers to automatically differentiate between borrowers of varying credit quality. Prior to the 1980s credit cards were relatively rare and rates were high regardless of your credit score. After 1980 rates began to vary…borrowers with high scores were charged less and borrowers with lower scores were charged much more. Risk assessment. But also as a loss leader. The guy with the high score had more money to deposit and would probably need an auto loan and a house loan.

Add in the ability to securitize loans in the late eighties and banks could keep the liability off their books and keep on lending.

Different world today.

Cap the rates and credit will diminish at the top; low score borrowers. Securitization isn’t dead but it’s in Intensive Care. New rules will keep the liability on the lender’s books.

Credit won’t go away, but it will greatly diminish. It already has and there’s not a cap…yet.

Chase and BofA have been terrible. I paid down my cards by 50%. They then reduced my limits. Shortly afterwards they raised my rates because my cards were maxed…they weren’t maxed when I paid off 50% of the balance. They were only maxed after they cut the lines in half.

Posted by imLyle | Report as abusive

Debit cards are a poor replacement for credit cards; they don’t have the same degree of safeguards.

What we need is some kind of credit card that acts like a debit card; almost like a credit card being run with a positive balance.

Posted by barrkel | Report as abusive

Juniper/Apple just raised my rate to 24.99 from 18.99. No reason. When asked they said to me “you’re not eligible for a rate reduction. My response? Paying it off now. Lost one hi-value customer. Only 2 more cards, one 8% and one 11% to go.
Good luck all ! POS

Posted by Anonymous | Report as abusive

There is a flawed premise on credit card profitability baked into this thinking. It is not true that non-interest paying card holders are not profitable. For Visa and MasterCard low credit risk card holders with reasonable transaction volumes (i.e. over about $7500 per year) can be suitable profitable- with a pretax ROA of about 2% at that spending level. Folks like this who use cards for transactional purposes and those that use cards for credit use purposes are nearly 100% unrelated to each other (absent occasional transitions from one category to another) and there is no cross-subsidy (other than maybe some leveraging of fixed cost computer platform type functions). Depending on how the consumer uses the card, credit cards should be thought of as two different products when analyzing concepts like those in this post. The subsidy that IS happening is that consumers who do not use a reward-based card product for as many purchases as possible are subsidizing those that do through generally higher merchant transactional costs (which, as a ‘cost of goods sold’ ultimately is an expense input that is passed back to all consumers in more or less efficiently priced product categories). All credit card issuers are happy to have high volume low risk consumers (Amex in particular, with its higher interchange rates); the repricing that is going on is merely (i) a predictable reaction to the CARD Act and (ii) a too late recognition by the issuers that they had underpricing unsecured credit for a decade or more- despite what individual card holders feel about their own credit worthiness.

Posted by TRKAdvisors | Report as abusive