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The Future of Consumer Credit...Today

posted by Adam Levitin

Paige and Jeremy have had some wonderful posts this last week, and although I have not been deputized to be their official host, I want to thank them for really pushing the behavioralist perspective.

I want to take up the final question Paige and Jeremy posed, however. They ask "Will the terms of consumer credit improve (lower interest rates, more frequent flyer miles) or worsen (higher late fees, more invasive collections practices)?"

We already know the answer, because the future is here today.

This isn't an "either/or" question. Over the past two decades we've seen both trends happening in the credit card industry. The card industry is the most sophisticated consumer lending industry in the world, and thus may represent the future for other types of lenders.

The card industry has realized that they can capitalize on consumer cognitive issues (not just hyperbolic discounting and underestimation, but also simple inability to process multiple complex price points). Thus the highlighted interest rates (teaser rates and base rates) are lower and rewards programs have grown (but with lots of fine point restrictions that makes them quite hard to value rationally). Teaser rates and frequent flier miles encourage card usage--it looks like a great deal. But at the same time back end fees have soared (160% and 115% for late and overlimit fees from 1990 to 2005). And billing tricks and traps have sprouted up like crabgrass. There are now so many price points for cards that disclosure is meaningless--even if consumers read the terms and understood them, it is impossible to process them all an know the effective cost of using credit before borrowing. This is venus flytrap lending: lure the consumers into card usage with teaser rates and bundled benefits and then catch them with tucked away fees and billing practices.

So how do the increased benefits and increased costs net out? There's really no way to tell. Most likely, some consumers (transactors or revolvers who never pay late and don't get hit with penalty interest rates for any reason) have benefitted from this situation and others have suffered from it (revolvers who fall into the penalties and fees).

But the fact that it isn't possible to net out the increased benefits with the increased costs is quite telling. Consumers simply do not and cannot know the cost of using credit cards prospectively unless they know with absolute certainty that they will never revolve a balance (i.e., not really using credit other than float) or make a late payment (which is not entirely in their control). The sheer number of price points, coupled with billing practices like unilateral retroactive term changes and cross-default clauses, make it impossible to anticipate the cost of credit. And if consumers don't know the cost of using credit cards, it follows that they cannot be using them at efficient levels.

We need to look at the net picture when we evaluate whether the terms of consumer credit are improving or worsening, but at the same time we need to recognize that within that net picture there may be some winners and some losers. Changes in consumer credit have different impacts on different consumer populations, and this complicates regulatory responses to manipulative lending practices. The sad truth is that we may not be able to do regulation that is Pareto optimal, at least in regard to consumers.

As much as I would love to see the gentle nudges of libertarian (or asymmetric) paternalism succeed, I suspect that going forward we will find ourselves having to debate the merits of employing the sharp elbows of old school paternalism for core consumer credit issues. Libertarian and asymmetric paternalism can be employed to overcome some cognitive issues on the consumer side. Whether they can be used to prevent business' exploitation of consumers' cognitive issues is another matter.


I completely agree. Credit card terms are incredibly obtuse.

One would need a computer program to figure out the terms. And I am sure that the credit card companies have one.

Try an experiment. When you get a late fee, call the 800 number and ask where on the contract you signed the late fee came from. They don't know. Then ask to speak to someone who does know. You will come to a dead end.

The contracts are all BS. Yea, I understand that credit cards are supposed to be month to month contracts. And credit card companies want to charge appropriate interest rates for the relevant risk. But if they keep doing this, they may screw themselves out of business. Cash could be king again.

I may be misunderstanding the intended purpose behind the inclination to 'net' things out. But, I suggest that this is actually a mistake. Too often we ask questions at too high a level of abstraction such as, "On the whole, when we net things out, how does this that or the other practice look?"

We'd be wiser to disaggregate instead of aggregate. There is little question that credit card companies cause tremendous damage to human beings who are in one or more categories of credit card abusers. While there may be other categories who benefit from the company approaches, our worry should remain with those who are damaged. And we should use all means available to address these issues -- whether regulatory, legal, non-profit, or private sector.

When, instead, we debate about the overall picture of 'netting' things out, we distract ourselves.

Unfortunately, I think the only way that any sector of consumer credit is going to straighten out - never mind actually BENEFIT a consumer - is simply by the hand of the market. And that's only going to happen if an entity actually offers, in this instance, a credit card that has simple, easy to understand black and white terms - i.e. "pay this amount on this date every month. If you are late, you have to pay this much extra. Pay on time every month for X months and we may even throw in a free widget." And just KEEP the terms that simple instead of trying to screw the consumer out of every penny possible.

Any kind of legislation on the topic is potentially doomed out of the gate simply due to the lobbying power of the MBA and other financial interests.

Another catch - the only way my example survives is if it catches on and becomes so popular so quickly that the rest of the industry simply CAN'T bludgeon it back into oblivion.

Consumers, for the most part, really aren't stupid. Some are more ignorant than others but once given all of the facts even they tend to catch on eventually - especially when they realize that they're being screwed. The next entity in ANY sector that tries dealing FAIRLY with a consumer could very well be the next "king of the mountain."

Of course, I'm not going to hold my breath until that happens...

Amen Mike!

I think there should be mandatory High School Classes that teach kids how to read credit card contracts, mortgage contracts ALONG with teaching the do's and don’ts of credit. ie. Don’t' use credit cards to go out to eat! Especially if there is a balance that you already can’t pay off at the end of the month! That way at the very least our kids will be better prepared to enter the “real world”.

It’s hard enough for me to read credit card contracts, how are blue collar workers going to figure them out? A lot of the card contracts are footnoted like legal briefs and wording is so small you have to have a magnifying glass to read!

One other thing. There is no constitutional right to a credit card with a low interest rate. One of the problems with a low interest rate is that, with inflation, there is no profit to lending. Hence, states with usury laws got screwed.

So, for a non-secured loan, made on a month to month basis, what is the correct interest rate? For some, it is 0%, or so it seems (pay off you debt each month). And with "cashback" bonuses, they are actually paying me to use my credit card. Fancy that.

On another not, has anyone examined the effect of the Texas constitutional amendment (circa 1995?) that permitted Texans to take home equity loans for any purpose? Used to be that second mortgages could only be used to pay for household improvements. Texans did not like that because they would still have debt, but they could not deduct the interest...

Would the transparency buffs be satisfied with the fixed-fee payday loan?

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