Tuesday, July 8, 2008

Credit Card Fee Regulation: Could Disclosures Stimulate Competition?

Taking a break from blogging about merchant fees, this week’s post looks at the current debate with respect to credit card regulation. Although some in Congress have been thinking about merchant fee regulation, the hot action currently seems to be on the cardholder fee side.

For the last several months, Congress has been kicking around whether new regulation should prohibit certain practices or simply mandate more effective disclosure. Senator Ron Wyden is pushing the disclosure angle through an interesting star rating system, while Senator Carl Levine, among others, favors prohibitions. In May, the Federal Reserve proposed regulations aimed at some of the same concerns, and this weekend, a New York Times article indicated that the tide seems to be turning away from disclosure and in favor of direct regulation. Although a number of practices pop up in the various bills and regulations – mandatory arbitration provisions; charging interest on debit paid within the grace period; over-the-limit fees for approved transactions; fees for paying the bill by phone – every proposal takes aim at the practice of first allocating payments to lower interest rate debt.

I agree that this practice can be particularly egregious. A card company can lure a consumer into transferring a large balance with the promise of a low interest rate while charging “transaction fees” on the balance transfer that will be subject to interest. A consumer who spots the transaction fee may miss that the deal includes a relatively high interest rate on all new purchases. Even the wily consumer who catches both the transaction fee and the high rate on new purchases may mistakenly assume that she can simply pay off her new purchases within the grace period, avoiding interest. If the card company allocates payments first to the low interest balance transfer, however, the account will accrue interest at the high new purchases rate until the entire old transferred balance is completely paid off. Even if the cardholder paid more than the sum of the minimum payment on the balance transfer and the cost of all new purchases for that month, interest would begin accruing on the new purchases because the entire payment would be allocated to the low interest balance transfer. Yikes, by the time the old balance is paid off, the cardholder is likely to have a new one that is just as large and probably at a higher interest rate. Would you have caught all that? I admit, I’ve been caught a few times, and I’ve been studying credit card offers for over a decade.

One can debate how well the various proposals would actually protect consumers given the flexibility that card companies have in structuring their offers. Ironically, a disclosure requirement could be more effective in combating the payment allocation concern. Some may argue that card companies already disclose transaction fees and the allocation of payments among varying interest rate debt. Of course, the current methods of disjointed, fine print disclosure leave consumers who are not financially sophisticated unable to understand the terms of their agreement.

What’s needed is a disclosure along the lines of those provided by mutual fund companies. Those companies provide a return and fee breakdown based on a hypothetical investment. Credit card companies should be required to do the same. They should disclose all of the charges that they would assess on a hypothetical balance transfer and new purchase balance of, say, $1000 each. In addition to interest charges, the card company should be required to include all transaction fees and other fees that a cardholder might be expected to pay over the course of a year. For example, if the average cardholder pays one late or over-the-limit fee annually, that fee should be included. If the card company offers a reward or rebate, it could incorporate that into the disclosure as well. Most importantly, in type as large as the largest on the mailing or other offer, the card companies should be required to disclose the effective net interest rate – calculated pursuant to a formula developed by Congress or the Federal Reserve – that a typical cardholder would pay if the hypothetical balances were maintained for a year.

By mandating this sort of disclosure, even unsophisticated consumers would be able meaningfully to compare offers from various issuers. The comparison would be nearly as simple as comparing differing annual fees. The resulting competition might well protect consumers more effectively than prohibiting any particular practice.


Anonymous said...

Professor, please paragraph.

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