“Shock and Gall” – The Penalty Rates That Might Eat Your Wage Gains.

By now most Credit Slips readers know that new federal credit card unfair and deceptive acts or practices, or “UDAP,” rules will prohibit banks from applying rate hikes to existing balances in most cases.  (The big exception will be where payment is more than 30 days late.)  This is a major improvement – or it will be, in July, 2010 when the rules become effective.

In the meantime, how might the steepest of the rate increases – penalty rates – impact household budgets during the next year of the financial strains that recession brings?

Let’s start with what happened to those budgets during the recovery period after the 9/11 slow-down, from 2002-2006.  For the “bottom 90%” (doesn’t “bottom 90%” ring some warning bells about what’s happened to our middle-class?),  there was an average increase in income of less than $1500 for that whole 4-year period (as calculated by Chye-Ching Huang and Chad Stone at the Center for Budget and Policy Priorities). 

According to a study that my colleague at the Center for Responsible Lending, economist Josh Frank, recently released, that 4-year gain and more would be wiped out by one year at the penalty rate on the average balance for a revolver.  In Priceless or Just Expensive?, he estimates that the penalty rate shock on the average $10,600+ balance would cost an extra $1800 over a year:  less than 10 months of rate shock differential equals 4 years of wage gains.  Josh estimates that some 11% of balances are ticking at penalty rates. 

And that rate shock is getting sharper.  The average penalty rate in 2008 was 28.6% -- up from 22.6% in 2002.  But more mind-boggling is the jump in the spread between the standard purchase rate and the penalty rate:  that more than doubled from 2000 (an 8.1% difference) to a nearly 17% spread in 2008.

The standard justification for penalty rates is that it is risk pricing, and that it acts as a deterrent to irresponsible behavior.  Josh, like others skeptical of that rationale (such as Prof. Levitin), suggests it might better be thought of as “excuse-based pricing.”  And, of course, the current menu of triggers for penalty rates that have little to do with delinquent behavior cast more than a little doubt on the “deterrence” argument.  But it also appears as though the majority of borrowers being charged penalty rates don’t know that they are.  Hard to be deterred by that of which you are unaware. 

That lack of awareness is not surprising to behavioral economists:  a survey of card issuer mailings to 9700 households over a 2 ½ year period found only one that actually gave a customer a heads up on an increased penalty rate.  That, too, will change when the new rules go into effect and a 45-day advance notice will be required.  In 2010.

Comments

[Adam Levitin]

2010 isn't soon enough, and neither is an opt-out right. Opting out of a rate increase requires closing an account. That imposes a real cost on consumers. First, the consumer has to take the time to close the account and find a replacement account. There are some transaction costs there. Second, closing a line of credit can hurt your credit score. Because credit scores are a black box, we don't know the exact impact, but it is fair to say that closing your account will mean that you will pay more credit in the future. So the consumer bears the cost either way. This is particularly galling when the rate increase is because of the bank's inability to handle credit responsibly, not the consumer's.

For example, Citi has been raising rates on cardholders to cover its own losses on bad mortgages, etc. The risk-based pricing is that Citi cardholders are paying the price for the risk created by Citi mortgagors and Citi's trading desk. I'd rather do without that sort of risk-based pricing.

There's a risk, of course, that Citi will lose some cardholders, but Citi knows that consumers are reluctant to surrender lines of credit currently, as they are worried about their ability to find new lines. So Citi is hoping that there's a higher than normal lock-in effect.

[Patches]

I agree. Not soon enough. I received a seemingly great offer from B of A the other day. As I read down, as I usually do, I saw that they could change the terms of the contract for any reason at any time. I assume even if I am current on payments; not over the limit or have not defaulted on any other "whatever" (mortgage, car, credit cards, line of credit, etc....).

Uhhhhh...... No thanks, despite that seemingly attractive 0% interest on balance transfers. Otherwise I might have taken them up on their offer. That is no way to get me off the "sidelines" that's for sure. If they really want me to take them up, they should have something to the effect.... "Only if you default on your payments on this card".