Blogs & Comment

Cheap credit, RIP

Sid Lokash (name has been changed) is a New Yorker who regularly uses credit cards to help him make big-ticket purchases. Last fall, for example, he put several thousand dollars on one card in order to send his mother to India.
At 18.7%, that card’s interest rate wasn’t great, and new debt piled. So when Capital One offered Lokash a new credit card with what looked like fabulous terms zero percent interest for the first six months he bit. He took the card, and transferred much of the debt he owed on the first card to the second.
What Lokash didn’t see was the fine print. Should he be late on a payment, or God forbid, miss a payment, Capital One reserved the right to hike the interest rate to a whopping 23%. Sure enough, there came a day this past winter when Lokash missed a payment. Next thing he knew, he was paying interest charges of up to $90 a month on his fall debt.
Such personal indebtedness is rife on both sides of the border. One couple featured on Oprah on September 23rd of this year owned a home that was worth less than they had paid; had recently endured a layoff; had no health insurance; and were living off of 29 credit cards. Lokash’s case is mild in comparison. But all that debt adds up. At the end of 2008, Americans’ credit card debt reached $972.73 billion, up 1.12% from 2007. (That number, sourced from sector watchdog www.creditcards.com , includes both general purpose credit cards and private label credit cards that aren’t owned by a bank).

To mitigate against such a teetering mountain of personal indebtedness, today the Obama administration announced the passage of the Credit Card Accountability, Responsibility and Disclosure Act. The law is designed to prevent what’s described as “unfair” rate increases, put a stop to unfair rate traps and late fees, and ensure the terms of contracts that are disclosed in plain language, in plain sight. Credit card issuers have nine months with which to adapt to the new regulations. Hence Lokash’s and many other American consumers’ difficulties, as banks hereabouts tighten their terms of credit and jack up rates.

Of course, a law that is designed to protect consumers will also have a real and measurable impact on banks’ willingness to issue credit to consumers in the first place.

“This law signals we are moving back to an era of real underwriting and real pricing,” explained Ellen Seidman,financial services policy director for the New America Foundationin Washington, D.C. “We’ve all been free-riding for years on cheap credit; this law ensures people will have to pay for that credit in a timely and appropriate manner.”

In Seidman’s view, it’s the rules around how banks alter the interest rates they charge are likely to have the most immediate impact. “This legislation basically puts an end to the cheap-credit model,” she says. “In the past, any time an issuer became concerned about the ability of a customer to pay their past debts, they simply raised the rate they would charge. That is what they will not be able to do anymore.” That means fewer people will have access to credit. “But those who receive credit, will get it on terms that are priced more fairly, thus ensuring that credit will be repaid,” she said.

The new laws also imply a change to the way American workers get paid. People will no longer be able to use their credit cards as a form of bridge financing to supplement inadequate paychecks, Seidman said. To sustain demand, the wages of average workers may finally start to increase in step with inflation, after several years of remaining stagnant.

Similar legislation is in the works in Canada. This week, Finance Minister Jim Flaherty proposed nine new regulations that would rein in the use of credit cards. The highlights of those proposals include a 21-day grace period on new purchases, provided the outstanding balance is paid in full; card issuers must also supply consumers with notice before making a change to their interest rate on an existing balance. The Canadian proposals differ in that Flaherty is not pushing for legislation that limits a card issuer’s ability to increase rates “unfairly” on existing balances, or introduce most new fees. Issuers can still raise rates but they must provide the consumer with “adequate” notice before doing so.

It’s difficult to tell what impact this legislation is likely to have on the U.S. economic recoveryand by extension, that of Canada. But in the meantime, think it through: what do the Canadian proposals imply for your use of credit cards, and what is the new legislation’s likely impact on the U.S. economy, as it struggles towards recovery? Have your say at www.canadianbusiness.com.