Worst Practices: Residual Interest
Professor LoPucki's APR issue might not be two-cycle billing as many of the commentators think. Just as likely, it is residual interest (a/k/a trailing interest), the often ignored, but just as potent cousin of double-cycle billing.
Residual interest has not gotten nearly as much attention as it should (and it is often confused with double-cycle billing). Residual interest is a nasty billing trap that drains away discretionary income (also known as potential savings) from American consumers, and should be at the top of the Congressional hit list for predatory credit card billing practices.
Residual interest is not an intuitive concept. The key to understanding it to remember that finance charges apply to the average daily balance outstanding during a billing cycle. Billing cycles start, however, before the old billing cycle's bill has been sent out and payment has been received. If payment on the preceding cycle is received in full and on time, then it is not included in the average daily balance. But if even a penny of it is late or not paid, then the previous cycle's balance is treated as outstanding for the days that would otherwise be in the grace period.
By way of comparison, double-cycle billing calculates an average daily balance based on the current and past billing cycle (this can actually be beneficial to cardholders in some circumstances, such as when there was a zero balance in one cycle). Double-cycle billing can be combined with residual interest, so that charges from a third billing cycle that are paid off during the grace period still are figured into the balance calculation. What both residual interest and double-cycle billing share is that they calculate the average daily balance to which the finance charge is applied by including amounts that have been timely repaid.
To illustrate how residual interest works: if you charge $500 in cycle 1 which ends on September 30, you do not get a bill until, say, October 7, after the start of the October billing cycle. You then pay $450, which the issuer receives on October 12 (on time). You then on October 16 charge another $200. Your total daily balance for the October billing cycle (closing on October 31st), is calculated thus:
Oct. 1-Oct. 12 (12 days @ $500)=$6,000
Oct. 13-Oct. 15 (3 days @ $50)=$150
Oct. 16-Oct. 31 (16 days @$250)=$4,000
Total Daily Balance: $10,150
This is then divided by the number of days in the cycle (31), yielding an average daily balance of $327.42, to which the finance charge is applied. 14.49% compounded daily for 31 days on $327.42 is $4.05.
Notice that you paid $450 back on time, but are still assessed interest on it. This would be true if you had repaid all but a penny on time. But for residual interest, the average daily balance would be ($250*16 + $50*12)/31=$161.29, so interest would be applied to a balance that is 55% lower! At 14.49% APR interest, compounded daily, the difference is that between paying $4.05 in interest for the month for residual interest or $2.02 (no residual interest).
That doesn't look like a big deal (although there is a lot to be said for a business model that makes lots of money in small increments), but consider if the balances had an extra zero, and were carried for a year, instead of a month. In such a case, residual interest would be the difference between paying $510.42 in interest instead of $255.19 in interest. Again, the extra $255.23 doesn't seem like a big deal...unless you consider it in the context of many families' discretionary income.
For a household making less than $50,000 per year, this extra $255.23 in interest represents 13% of their discretionary income. Even for wealthier households, earning $50,000-$99,999 per year, it is over 2% of discretionary income. Imagine if every household's discretionary income rose 2%--that would be serious economic growth. Billing tricks and traps like residual interest drain away spending power from American consumers.
Here's the other thing about residual interest: it's fully disclosed. This tells us that TILA disclosures are useless. The published APR is 14.49%, but it is applied in a way that no one understands to yield an effective APR of 29.23% on the balance that was actually revolved. Grace periods only apply if the balance is paid in full and on time. Otherwise, residual interest kicks in. If Lynn LoPucki, one of the leading credit scholars in the world, didn't catch the residual interest trap (or the double-cycle billing, which is almost certainly in addition to residual interest) in his card disclosure, can we really expect that any one else will? TILA has become a means for obfuscating credit prices, not for their disclosure. If we want credit markets to work and to enable consumer responsibility, we have to fix TILA, and that starts by banning billing practices that manipulate disclosure rules.
[Updated with technical corrections, 10.25.08 at 8:16pm. Updated again with further technical corrections 10.26.08 at 3:50pm.]