Bailout

Why credit-card interest rates won?t be capped

By Felix Salmon

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.

Full post as published by Macroprudential on December 29, 2009 (boomark / email).