Why capping credit-card rates won’t help consumers

BOSTON (MarketWatch) — If we want to get the economy back on track, maybe we should pass a law that puts a cap on the interest rate banks can charge on credit cards. Doing so, according to proponents of the idea, would free up of billions of dollars that consumers could then use to inject life back into the economy.

Here’s the theory: If the government forced banks — which are on the hook for some $800 billion in credit card debt — to limit the spreads on their credit card interest rates to, say, 10 percentage points over prime, that could pump an estimated $5 billion directly into consumer pockets, as opposed to bank vaults.

But that, say credit card experts, isn’t exactly what would happen.

Greg McBride, vice president and senior financial analyst at Bankrate.com, said two things would happen if government forced banks to cap the spread on credit card interest rates to some percent over prime:

For one, it wouldn’t change rates much, and two, it would have the opposite effect of that intended. “It would further restrict credit to households with less-than-stellar credit,” he said. “And having the government put in place controls that limit credit would have the exact opposite effect.”

To the first point, what we know is this:

The average credit-card interest rate on existing balances is about 13%, according to Federal Reserve’s credit survey. And given that the current prime rate is 3.25%, a 10 percentage-point-over-prime cap wouldn’t change much today for Americans who have credit cards and who have on average nearly $16,000 in such debt, according to CreditCards.com.

Also, 40% of the households with a credit card pay off their balance every month and 60% carry a balance. It’s the 60% who tend to pay more than 13%. And putting a cap on the interest rate charged those folks could put some money back into the economy, according to Dean Baker, an economist at Center for Economic Policy & Research.

“The 13% is an average rate,” he said. “Some people are borrowing at 6% to 7%, but some are paying 20% to 25%. This means in principle this cap would save a decent chunk of change.”

How much it might save, however, is the question of the day. To get at the answer we tried this exercise using the Federal Reserve’s Credit Card Repayment Calculator. Let’s say you have credit card holder with a balance of $16,000 and an APR of 20%, a scenario that might describe roughly 54 million households by my calculation. If that credit card holder makes only the minimum payment on time each month and makes no more charges, it would take 78 years to pay off the balance and that credit card holder would pay about $78,000 in interest over that period of time.

By contrast, if you took the very same scenario and reduced the APR to 13% what happens is this: The balance would be paid off paid in 31 years — 47 years sooner than at an APR of 20%. Plus, that credit card holder would pay a little more than $18, 000 in interest, some $60,000 less in interest.

By my estimate, by capping the interest rate to 13% what you would save – if my numbers are right — is some $3.2 billion in interest payments over 50 years (or $65 million per year) — starting 30 years from now.

Hardly enough to jump start a $15 trillion economy.

The Federal Reserve’s Credit Card Repayment Calculator can be found at this website.

And to McBride’s second point — that capping credit card interest rates would have negative effects — experts said the following:

“If this cap is imposed, it will probably save indebted consumers more money than it should,” said Scott Rick, an assistant professor of marketing at the University of Michigan’s Ross School of Business, and co-author of a just-published study on consumer debt.

“When consumers are faced with multiple debts, we find that the size of the balance is a better predictor than interest rate of how eager consumers are to repay a particular debt, which is generally inconsistent with rationality. So they may be distracted by a small debt while a larger, higher-interest debt continues to rack up interest charges, a mistake we call ‘debt-account aversion.’ If there’s some kind of cap on interest rates, that won’t prevent this mistake, but at least it will make the mistake less costly.”

Read Scott’s study, “Winning the Battle but Losing the War: The Psychology of Debt Management.”

And still others note capping credit card interest rates would adversely affect the profitability of banks to the consumer’s detriment. “The concept that it is a good idea for the government to force banks to take a cut on existing loans and lines of credit is nonsense,” said Odysseas Papadimitriou, the CEO of CardHub.com. “What happens when the banks do not have money to cover their losses and risk becoming insolvent? Taxpayers pay the bill again?”

Of note, the Federal Reserve does produce a report detailing just how much money banks make from credit cards.

Read the Fed’s report, “Report to the Congress on the Profitability of Credit Card Operations of Depository Institutions.”

And Papadimitriou agreed that capping interest rates would be a net negative to the economy and to consumer. “Banks will just stop lending money on consumer segments that turn unprofitable after the interest rate caps,” he said.

High-cost borrowers have high default rates, Baker said. “If you cap the fees at 10 percentage points above prime, then you will deny many of these people credit,” he said. “That would be a very mixed bag for the economy and not necessarily a great thing for these credit card holders.”

By the way, the national average default rate as January 2010 stood at 27.88% and the mean default rate is 28.99% according to a CreditCards.com survey published in January 2010.

In many ways, McBride noted, the CARD Act is already restricting many high-cost borrowers from credit. He said, for instance, that many Americans with a credit score below 700 cannot open a credit card account. What’s more, he also noted that the CARD Act already restricts banks from raising credit card interest rates indiscriminately. Banks can only raise interest rates on existing cardholder accounts that are 60 days delinquent.

From his perspective, what is helping the economy right now in a very real way is the Home Affordable Refinance Program (HARP), which allows home owners to refinance into low mortgage interest even when the property has decreased in value. With the HARP program, homeowners get to reduce their mortgage immediately, freeing up money that could be used for saving or consumption. Plus, the HARP program reduces the possibility of someone defaulting on an obligation.

The HARP program has a bigger impact than putting a cap on credit card interest rates, McBride said.  –Robert Powell, MarketWatch