Jorge Amador has written for the Philadelphia Inquirer and Daily News, the Orange County Register, and many other periodicals.
Interest rates on home mortgages are hovering around 10 per cent and car loans are no longer unusual at 7 per cent, but most of us are still paying annual rates of 18 per cent or more on our unpaid credit card balance. Why?
“It’s a ripoff,” says Elgie Holstein of the Bankcard Holders of America. There is a widespread feeling that banks are somehow taking advantage of credit card users. Illinois treasurer Jerome Cosentino has withdrawn some $2.2 billion in state funds from two Illinois banks in protest over rates close to 20 per cent. Alan Fox of the Consumer Federation of America blames “credit card profiteers” for what he calls “irresponsible exploitation of credit card consumers.”
At least five bills have been introduced in the last two Congresses to clamp down on credit card interest. Last spring a subcommittee of the House Banking Committee approved a proposal to cap rates at 8 per cent above the yield of one-year treasury securities—setting the ceiling at 13.8 per cent using the rates then in effect.
Richard Kessel, executive director of the New York State Consumer Protection Board, warns that interest- rate ceilings may have to return to bring card charges in line with other rates: “The fact is that . . . deregulation is not benefiting consumers when economic conditions clearly warrant a decrease in interest rates.” He adds, “Deregulation is a good idea when it promotes competition, but in this caseit has not. Financial institutions and retailers have not been motivated to lower their credit card interest rates.”
Competition or Oligopoly?
“I think the answer is self-evident: there simply is a lack of competition in the credit card business,” says Tennessee Senator Jim Sasser. “A relatively small number of very large card issuers keep these rates artificially high.”
In a statement before the Senate Banking Subcommittee on April 21, 1987, New York Congressman Charles Schumer declared, “In every other one of those [credit financing] areas there is genuine and real competition—the free market is working. In credit cards, we have oligopoly.” Schumer theorizes that the credit card market is dominated by a few large issuers who exercise “price leadership” to hold the line at a high rate.
How competitive is the credit card market? In 1986, Americans held 731 million credit cards from 15,000 issuers. The largest single issuer, Sears, accounted for 11 per cent of all credit card balances outstanding at the end of 1985.
Citicorp, the largest bank card provider with 9 million, had less than five per cent of the 186 million bank cards issued in 1986. Together the ten largest issuers accounted for less than one-fifth of the bank credit cards issued to consumers.
To be sure, no consumer has access to thousands of sources of credit in his geographical area. But credit cards are primarily a mail-order business. :In principle any person could write to every issuer, apply for their cards, and shop :for the best deals. Retailers may not be interested in giving cards to people who don’t live near their outlets, but on the other hand some banks aggressively seek customers across the continent.
As Senator Phil Gramm of Texas observes, “I have access to the mails,” and through them “I have access to credit cards. Is it not right that I have more access to more different sources of credit and general credit cards than I have access to grocery stores and to drugstores?” The consumer is limited to the grocers and drugstores in his area, but he isn’t limited to the banks in his area.
The rate of interest is only one of the elements of revolving credit plans that may be subject to competition among issuers. Credit card programs vary widely over such features as:
• Annual card fees. The fee charged for having a card ranges among issuers from none to $25 and higher. Sears offered a no-fee first year to attract applicants to its Discover card.
• Transaction charges. Cash advances made against the credit line (as opposed to card purchases) usually but not always incur a per-transaction fee, ranging from 50 cents to $1 to a percentage of the cash advance.
• Length of the grace period. The grace period or “float,” the interim between the moment you charge your purchase and the moment interest begins to accrue, is typically 25 or 30 days. Some banks do not offer grace pe riods and charge interest on all purchases and cash advances made during the month.
• Interest calculation method. The grace period might begin at the time the bill is prepared; or it might start on the date a purchase is made or posted, which gives the customer less time to pay before interest begins to accrue.
• Discounts and enhancements. Citibank offers “Citidollars” on every purchase. These “dollars” can be traded in for discounts on merchandise bought through the issuers.
The First National Bank of Chicago offers special “First Card Checks.” These notes are used like checks and serve as an emergency cash advance when a bank or electronic teller is unavailable.
Other credit card issuers have tried pre-ap-proved credit lines, low-cost insurance, and rebates on purchases made with their cards. “Some creditors even prefer to compete with discounts on winter cruises than modest interest reductions,” observes The New York Times.
So, if card issuers are competing on all these fronts, and the market is truly so free, why aren’t they competing on the basis of interest rates, too? Isn’t it the case that, as Alan Fox says, “The market won’t be allowed to work by those with a stake in high interest rates”? Hasn’t competition failed here?
There are two answers: Some are indeed competing on the basis of interest. But most won’t compete on that basis because they want to make credit available to a wide audience.
Some banks do offer substantially lower interest rates. Groups such as Holstein’s Bank-card Holders and Fox’s Consumer Federation regularly publish lists of low-interest banks, some charging less than 12 per cent. But these banks seldom exploit their rate advantage through mass marketing. All else being equal, banks with higher rates can better afford to offer their cards to a nationwide audience. It is of little use to consumers for a bank to have low rates if they don’t hear about it.
Looking at the Costs
The credit card is one of the most convenient ways to borrow money, but it is also one of the costliest ways to lend money. Whereas a home mortgage may run over $100,000 and a car loan over $10,000, the average bank card transaction is $50. Even in today’s automated environment, processing constitutes a higher proportion of the transaction costs the smaller the transaction is.
“In fact,” says Jerry Craft of the American Bankers Association, “administrative costs can account for more than half of the rate charged on bank credit cards. By comparison; only a little more than 10 per cent of the average mortgage rate can be attributed to administrative costs.”
The bigger the loan, the bigger the role that financing costs play in the rate. Financing cost is the price the bank pays to obtain the funds it lends to credit card users. “During the period 1974 through 1984,” said Federal Reserve Governor Martha Seger to the House Subcommittee on Consumer Affairs, “financing costs averaged only about three-tenths of total expenses, before taxes, for the credit card function at participating medium- and large-sized banks that issue credit cards. By comparison, financing costs at banks in the same size classes accounted for more than three-quarters of total costs of the commercial lending functions, and for nearly nine-tenths of total costs of mortgage lending.” Hence the greater tendency of such large loans to come down with the prime rate.
Craft breaks down the costs incorporated into the prevailing credit card rate roughly as follows: 7 per cent for financing; “up to 5 per cent” for administrative costs, including fraud; and 3 per cent for losses from customers who don’t pay their bills. He estimates the opportunity cost of the grace period at an additional 3 per cent. For these reasons Craft prefers to call the credit card rate a “service” rate rather than an interest rate.
Plastic money historically has been among the banks’ least profitable financial instruments. In the January 1987 Federal Reserve Bulletin, Glenn B. Canner and James T. Fergus show that profits on bank cards trailed those for commercial loans, installment plans, and real estate mortgages in six of the 14 years from 1972 to 1985. Pre-tax net earnings in the period averaged 1.9 per cent a year for credit cards, 2.3 per cent for mortgages, 2.4 per cent for consumer installment debt, and 2.8 per cent for commercial and other loans.
Cards yielded the highest average net returns in only four of the 14 years. Two of these were 1984 and 1985, when profits rose to 3.4 and 4.0 per cent. “But those margins attracted competition, and higher default rates and battles for market share have already lowered profits to a 3 per cent return on assets,” cautioned Business Week in 1986.
Canner and Fergus add that cards issued by department stores and other retailers have “consistently operated at a loss” through the years. Merchants find store cards useful because they profit from the additional sales that the cards facilitate, not from the interest they earn on account balances.
Given the record, Canner and Fergus conclude, “it seems unlikely that card issuers could absorb significant reductions in revenue from finance charges over the long term merely by accepting lower profits." Lowering ceilings on interest rates would threaten credit-card plans and customers, not just trim fat.
Dealing with Rate Caps
When faced with interest ceilings, card is-suers have to adopt strategies no more pleasant than the current interest rates. Banks were squeezed in 1979-81 when the cost of obtaining funds rose above the interest they were allowed to charge. According to Seger, “when market costs of funds rose sharply between 1979 and 1981 while credit card rates were restrained by the ceilings, marginal and even average net returns on credit card receivables turned negative.”
In response, “Some banks are considering charging card holders a yearly fee to help bring profits back up,” said one 1980 report on the credit crunch. Today, annual fees are the norm.
The grace period might be shortened or eliminated. Soon after the Connecticut legislature lowered the credit card rate ceiling from 18 per cent to 15 per cent in June 1986, some banks dropped grace periods. As one bank director put it, “We make money because we charge interest from the date of purchase.”
“You told us you’re looking for a credit card without a high interest rate. And we hear you!” reads a print ad for a major Pennsylvania bank’s Visa card. The chart advertises a “14.0 per cent annual percentage rate.” But the grace period on new purchases, says the chart, is “none.” Users must pay interest on every purchase whether or not they pay off their whole balance at the end of each month.
Tracy Mullin of the National Retail Merchants Association stresses that “retailers’ effective rates are well below the nominal Annual Percentage Rate that is disclosed. This is because a substantial portion of retail customers pay their bill in full each month, resulting in no finance charge revenue on such accounts” (emphasis in original).
According to Canner and Fergus, the proportion of customers who pay their bills fully each month is 47 per cent and 48 per cent of users with less than $10,000 in annual family income. Dropping grace periods would effectively increase the cost of credit cards to the millions of customers who treat their plastic as a convenient substitute for cash, clearing their balances at the end of the month.
Card issuers charge merchants a fee for every purchase made on their cards. This “merchant discount” ranges from 2 to 8 per cent, though on small transactions the fee may be a fixed amount. The discount could be raised in response to a rate ceiling, and ruer-chants might raise the prices on their goods to compensate.
Retailers with their own card plans might also raise their prices to make up the loss on such plans. Consider the case of Arkansas, a state with some of the toughest legislation against “usury” and hence some of the lowest credit card rates. Canner and Fergus report that major appliances, which are usually bought at credit, “were found to cost 3 to 8 per cent more in Arkansas—nearly 5 per cent more on average—than in neighboring states."
Interest Rates and Usury Laws: A Brief History
A legacy of the colonial period, tight lids on interest were common among the states until very recently. As late as the mid-1950s “the legal rate was 4 per cent in one state, 5 per cent in five states, 6 per cent in forty states, and 7 per cent in four states,” writes Sidney Homer in A History of Interest Rates. “A majority still clung formally to the 6 per cent tradition of the Stuart kings.”
These usury statutes “did not contemplate modern consumer credit. Under them there was often no legitimate capital available for small personal loans to urban workers,” writes Homer.
“In general the loans they demanded were too small and the risk was too great for them to be supplied profitably at rates permitted under the usury laws,” observes another analyst. “Lenders thus had to operate illegally if they were to engage profitably in a consumer cash loan business at all.”
“Loan sharks” supplied the common man with easy credit at exorbitant interest. Their importance declined when state governments began to permit lenders to charge for small loans at rates higher than the traditional ceilings.
Credit cards followed a similar, if less extreme, pattern of popularization. National plans began two decades ago “as an exclusive service for special customers whose ability to repay their debt was beyond question." As rate ceilings crept up to about 18 per cent, middle- and lower-income earners found it easier to get credit.
When credit card yields were last squeezed in 1979-81, millions of late payers and delinquent accounts were dropped nationwide. Eligibility standards for new applicants were tightened. Some banks refused new credit card accounts and others canceled their card plans altogether. In response, many states raised their rate ceilings up to 25 per cent, and some removed them completely.
Today, higher rates in most states permit banks to accept riskier customers. They have reacted to falling funding costs “not by reducing rates, but mainly by increasing the availability of credit cards.” This “increased availability reversed the earlier curtailment of such credit that card issuers undertook” as their funding costs rose through 1981.
Applicants with a spotty or limited credit record—primarily, but not exclusively, young and lower-income people—today can shop for banks in states allowing higher interest. A national rate ceiling would limit significantly their access to credit.
Simmons First National Bank of Pine Bluff, Arkansas, with a 10.5 per cent rate as of last March, is usually listed at or near the top of institutions charging low credit card interest. It makes a profit, but only by “being highly selective about whom it issues cards to, by funding the business with cheap local deposits and by taking advantage of its low overhead.
A 1979 Purdue University study comparing credit card holders in Arkansas, Illinois, Louisiana, and Wisconsin found that fewer Arkansans at all levels of education held bank cards than did comparable people in the states with looser rate rules. Surveys indicated that “a higher proportion of consumers reported being rejected for consumer credit compared with consumers residing in states with less restrictive rate ceilings.”
While 10 per cent of families with annual incomes of less than $6000 in the other states held bank credit cards, five per cent—half as many—such families in Arkansas had the cards. Ten per cent of Arkansas households headed by a person under age 25 had bank cards, compared to 19 per cent of such households in Illinois, Louisiana, and Wisconsin. Overall, 39 per cent of families in the other states had bank cards, but only 29 per cent of Arkansas families did.
Arkansans who can’t get credit in their state have the option to shop for cards with higher rates from banks located outside the state. Because a national rate cap would eliminate that alternative, we could expect its effects on credit availability to be more severe than Arkansas’ controls have been for Arkansans.
Populism or Elitism?
Interest rate regulation has a certain populist appeal. Politicians and consumer activists have denounced “usurers” and money-lenders, and made careers out of standing for the “little guy” against the big, bad banks.
Now we have an opposite class-based excuse for controlling interest rates. Said Elgie Holstein about the effect of credit card defaults on card rates: “1 think here much of the fault lies with the banks themselves, and not even all the banks, but simply those large interstate institutions that . . . mass-market credit cards . . . . I think if we were simply to look at their loss rates, what you’d find is that the banks that are mass-marketing cards indiscriminately are experiencing the highest loss rates.”
Senator Jim Sasser concurred:
I don’t believe that all consumers ought to be advanced credit. I think that credit ought to be advanced to those who are creditworthy. It appears to me that under the present credit card system, those of us who pay our bills are being asked to also pay the bills of the deadbeats who don’t want to pay. [I]f we advanced credit to those who are credit-worthy . . . the rates could come down very substantially, and the banks who advance the credit could make a reasonable profit, which they’re certainly entitled to.
“You’re exactly right,” Holstein told Sasser. “There is some economic level below which consumers not only should not have credit, but are poorly served if they are given credit.”
Elitism, too, rationalizes forcing card rates down. We responsible, well-to-do gentlemen ought to enjoy the benefits of credit; let the masses make do without it, as in the good old days. Since the banks aren’t cutting off the rabble in order to lower our rates, we’ll do it for them.
And indeed it is true that default rates on credit card accounts are climbing. A U.S. Chamber of Commerce economist reports that “Bank card industry losses since 1970 have fluctuated between 2 per cent and 4 per cent of credit outstanding. At the end of 1985 they were between 3 and 3.5 per cent; and credit card defaults in 1986 are expected to rise to 4.2 per cent of charges outstanding." Rising losses counteract the effect of falling financing costs on credit card rates.
Though we may find his attitude distasteful, Sasser’s point is understandable. Why should good credit risks subsidize poor risks?
An “Optimal” Solution
While politicians, regulators, industry lobbyists, and consumer advocates wrestle over legislative proposals, the market is already resolving the dilemma, accommodating all without government prodding.
In spite of all the factors militating against lower interest rates, some banks have lowered their rates voluntarily. American Express introduced the Optima credit card last spring with a 13.5 per cent rate.
American Express’s action was used by some as evidence that the marketplace “is working,” that it will and does respond to consumer dissatisfaction by reducing interest rates. Business Week dubbed it the “Credit Card War.”
“The greater consumer sensitivity to interest rates no doubt figured in Amex’s plans to take a plunge into the business with a lower-rate card,” cheered The Wall Street Journal. “Credit card interest almost certainly will come down. It will come down without rate ceilings. Nothing does it like competition.”
However, the Optima card is available only to those who already hold American Express charge cards. The annual fee for Optima is $15. On top of the $45 annual fee for Amex’s basic “green” card, it costs $60 a year to get the Optima card.
Applicants must meet more stringent requirements for American Express cards than for other cards to begin with. Indeed, this is part of the “snob” appeal of “membership” in American Express. The company isn’t even offering the new card to all “Cardmembers,” but only to those who have been members for at least one year and who have “solid credit histories." Thus Amex is marketing Optima at a high annual fee to a select group of proven, safe credit risks.
Despite the hopes of some friends of the credit card marketplace, Optima’s introduction has not led to a rate war. “Watch for small interest rate reductions on premium cards—those offering larger credit lines and requiring better credit histories,” advises Fortune.
The market “is working,” but in a different manner than its enthusiasts predicted. Amex’s gambit may lead to a stratified market where lower-risk customers can borrow at lower rates and higher-risk customers can find credit at higher rates. This would eliminate Sasser’s and Holstein’s objections against penalizing everyone for a few deadbeats, without drying up credit for the poor and the young.
We already have witnessed steps in this direction. In addition to Optima, there is Citicorp, which has cut rates to “preferred” customers to 16.8 per cent, while the rate for others remains at 19.8. Wells Fargo “dropped its credit card rate from 20 per cent to 17 per cent, but only for customers who’ve had a Wells Fargo bank card for at least five years.”
We could, in classical populist fashion, indict the market for treating better and worse risks differently, and call for a uniformly low rate. But this policy would do a disservice precisely to the “little guy” we would be trying to help. Instead of making low-cost credit available to all, it would dry up credit to poor risks and reserve it to good risks. Market segmentation permits access to credit to people of all backgrounds while rewarding those who pay their bills.
Free-market credit card rates make possible lower prices, greater access to credit, and other conveniences. If we get mad and force the rates down, we’ll bear the costs in other forms. One way or another, we must pay for our tastes. 
2. Statement by Elgie Holstein. associate director of the Bankcard Holders of America, before the Subcommittee on Consumer Affairs of the Committee on Banking. Housing. and Urban Affairs, U.S. • Senate, Washington, D.C., April 21. 1987.
15. Jerry D. Craft, “Bank Credit Cards: An Important Financial Option.” in “Are Credit Card Rates Too High?” symposium, At Home With Consumer,*, publ. by The Direct Selling Education Foundation, May 1987, p. 3.
17. Statement by Martha R. Seger, Member of the Board of Governors of the Federal Reserve System, before the Subcommittee on Consumer Affairs and Coinage of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, October 29. 1985. Printed in the Federal Reserve Bulletin, December 1985, p. 945.
The cyclical fluctuations of business are not an occurrence originating in the sphere of the unhampered market, but a product of government interference with business conditions designed to lower the rate of interest below the height at which the free market would have fixed it.
Therefore there cannot be any question of abolishing interest by any institutions, laws or devices of bank manipulation. He who wants to “abolish” interest will have to induce people to value an apple available in a hundred years no less than a present apple. What can be abolished by laws and decrees is merely the right of the capitalists to receive interest. But such decrees would bring about capital consumption and would very soon throw mankind back into the original state of natural poverty.
—Ludwig von Mises, Human Action