Credit Card Processing Blog

There has been a lot of buzz in the blogosphere about the sustained rise in U.S. credit card interest rates. In mid-December CreditCards.com – a website that conducts weekly surveys to calculate the average credit card annual percentage rate (APR) in the U.S. – reported the highest level they’d ever measured and the rate has only marginally decreased since then. Moreover, the average penalty rate has also increased, according to the website, even as many cards no longer have penalty rates.

So what’s causing this jump in interest rates? From what I’ve read, most commentators cite the CARD Act of 2009 as the chief culprit, because, by placing various restrictions on banks’ ability to charge fees and raise interest rates on existing accounts, it led to a substantial fall in card revenues, which issuers then had to find ways to make up for. I agree with this explanation, but I think it doesn’t tell the whole story and it doesn’t answer the question why the APR rise is so steep in recent months. I think that there is another reason for the more recent increase in average APR, one that hasn’t received any attention: issuers’ renewed interest in sub-prime borrowers. Let me explain.

Current Credit Card APR Levels

First, though, let’s take a look at the current CreditCards.com APR calculations. Here are the results from the website’s latest report (Jan. 4, 2012):

So what are we seeing here? While the national APR average has risen by 0.39 percent in the past six months, five of the nine categories that comprise it have registered a decrease for the same period and two have shown no change at all. Only two of the constituent categories have produced an APR increase. Additionally, only two of the categories – “instant approval” and “bad credit” – have an APR that is higher than the national average.

How Sub-Prime Drives APRs Upwards

So, our observations tell us that the only way the national average could have increased in the past six months would’ve been if the weight of the “instant approval” and “bad credit” categories had increased. So let’s examine these categories.

A look at CreditCards.com’s list of “instant approval” credit cards reveals that these are actually prepaid cards, so I’m not sure why they are included in a credit card list in the first place. Moreover, while the website tells us that approval for such a card usually requires “good to excellent credit,” each of the prepaid card offers they’ve listed explicitly states that “No Credit Check” is required, which is consistent with rules for prepaid card issuance. Prepaid is a type of card specifically designed to appeal to the “unbanked” and, far from requiring excellent credit, it is as sub-prime as it gets, which is why its average APR is higher than the national average. And we do know from Federal Reserve and other sources that prepaid is by far the fastest-growing type of non-cash payment methods in the U.S.

The “bad credit” category is much more unambiguously designating sub-prime card issuance. Here again we have plenty of data showing that there has been a huge increase in the number of cards issued to sub-prime borrowers. For example, Equifax – a credit reporting agency – told us that, while the total number of new credit cards issued in the first half of 2011 rose by 27 percent on a yearly basis, the number of cards issued to sub-prime borrowers (those with credit scores below 660) spiked by 64 percent for the period.

The Takeaway

So the data clearly tell us that the issuance of sub-prime credit cards is increasing at a much faster rate than the issuance of non-sub-prime cards (whose APRs are falling), pushing up the average national APR in the process.

Again, I’m not saying that the rise of sub-prime accounts for the entire post-CARD Act APR increase. It does not. Issuers clearly raised interest rates in anticipation of the CARD Act side effects and then kept doing it for a while. However, sub-prime card issuance is the primary driver behind the current APR rise.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

Last week we wrote about the U.S. Consumer Financial Protection Bureau’s ongoing crusade aiming to simplify credit card agreements, even as the CFPB’s own survey had found that consumers reported to be fairly satisfied with how the current, post-CARD Act, version is presenting the terms and conditions of these contracts.

As promised, the CFPB has now released its vision of a “shorter, simpler credit card agreement” and has posted it on its website for comments. Well, having reviewed CFPB’s version and compared it to a generic agreement, my conclusion is that it is neither shorter, nor simpler, although it is made to look that way. Let me explain.

CFPB’s Proposed Agreement

The bureau has split the credit card agreement into two separate parts. The first one lists the terms and conditions of the contract, which runs into two pages and I think that most Americans who have ever applied for credit cards will find it familiar.

The second part of the agreement consists of definitions of the terms used in the contract, listed in an alphabetical order. It runs into six pages, extending the total length of the agreement to eight pages, although it is presented as not being a part of the agreement.

Now let’s see how the proposed version compares to a currently used generic agreement.

CFPB vs. American Express

You can find generic versions of the agreements used by U.S. banks on CFPB’s website here. I picked the agreement used by American Express Bank, FSB, because this is one of the biggest U.S. issuers and I’m pretty sure it is fairly representative for the field.

The first observation is that the AmEx agreement, just like the CFPB’s, is split into two separate parts. The first one contains the terms and conditions and the second – titled “Supplement to the Cardmember Agreement” – provides explanations of terms, as well as a description of the associated rewards program.

Both agreements run into eight pages, even though the CFPB version does not have to describe a rewards program, which takes about a page of AmEx’s. So CFPB’s agreement is in fact a page longer than AmEx’s.

But has the CFPB managed to simplify the agreement? Well, let’s look at how the agency’s version explains the way interest is calculated:

How is interest calculated?

We calculate interest using the daily balance method with compounding. This means that interest compounds daily.

We will not charge you interest on purchases if you pay your full account balance by the due date each month. This is called a grace period. If you do not take advantage of the grace period, we will charge interest starting the day you make a purchase. If you do not pay your full account balance on time in any month you will lose your grace period until you pay your full account balance on time x months in a row. You pay interest on cash advances or balance transfers from [date].

Here is how AmEx has done it:

We use the Average Daily Balance method (including new transactions) to figure interest charges for each balance. The total interest charged for a billing period is the sum of the interest charged on each balance.

Interest

The interest charged for a balance in a billing period, except for variations caused by rounding, equals:

• Average Daily Balance (ADB) x
• Daily Periodic Rate (DPR) x
• number of days the DPR was in effect.

ADB

To get the ADB for a balance, we add up its daily balances. Then we divide the result by the number of days the DPR for that balance was in effect. If the daily balance is negative, we treat it as zero.

DPR

A DPR is 1/365th of an APR, rounded to one tenthousandth of a percentage point. Your DPRs are shown in How Rates and Fees Work on page 2 of Part 1.

I can’t find anything particularly novel in CFPB’s proposal. People will still need to look up what prime rate means and will still need to learn how to calculate compound interest, if they want to know what their interest payments will be.

Let’s take another example, this one informing cardholders when they have to make payments. First, CFPB:

We will send your bill to the address on file. You agree to pay all authorized charges on the bill, including interest and fees. You agree to pay us for charges that we allow over your credit limits. You must pay at least the minimum payment by the due date stated on each bill. Your minimum payment will be [insert formula].

Now AmEx:

You must pay at least the Minimum Payment Due by the Payment Due Date. The Minimum Payment Due and Payment Due Date are shown on each billing statement.

Each statement also states the time and manner by which you must make your payment for it to be credited as of the same day it is received. For your payment to be considered on time, we must receive at least the Minimum Payment Due in such time and manner by the Payment Due Date shown on your billing statement.

Once again, there is no difference. I can go on, but you get the idea.

The Takeaway

The point is that the CARD Act did a pretty good job at simplifying credit card agreements, as consumers have already told the CFPB. It is true that some terms are still not well understood, but I don’t think that any amount of explanation will change that.

In fact, the CFPB may be in agreement with me on that last point. For example, its proposed agreement refers to the compound interest rate in its explanation of how interest is calculated (see quote above), but it does not even attempt to explain it. I can understand why. The only way to do so in a meaningful way would involve a formula – A = P(1 + r/n)^nt – and I would bet you $10,000 (sorry Mitt Romney) a quarter that most Americans would find this confusing and would accuse the offending card issuer (or the CFPB, for that matter) of using math to hide the truth.

So yes, the CARD Act has already succeeded in simplifying and shortening credit card agreements and the CFPB is wasting government resources in its attempt to do it all over again.

Image credit: MyBank4.me.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

It seems like almost every day someone will “discover” yet another unintended consequence of the limit that the Federal Reserve placed on debit card transaction fees, which took effect in October. The latest such discovery that I’ve come across is made by WSJ’s Robin Sidel who is writing about the “nasty side effect” the debit cap is having on retailers selling small-ticket goods.

The thing about all these side effects is that they were all both predictable and described in some detail on this blog and elsewhere before the limit was enforced. No one who was paying attention and had bothered to look into the numbers should be surprised. This whole situation is strikingly similar to, though not quite as potentially apocalyptic as, the euro crisis in that in both cases politicians and pundits were gleefully ignoring early warnings from experts only to later declare, when those experts were proved right, that everyone was surprised with the way events were unfolding. But let’s confine our attention for the moment to the side effects the WSJ piece is focusing on.

What the Durbin Amendment Did

The Durbin Amendment to the Dodd-Frank financial overhaul legislation charged the Federal Reserve with the task of ensuring that the fees issuers charge merchants accepting their debit cards – the interchange fees – were “reasonable and proportional.” The Fed responded by placing an upper limit of about $0.24 per debit transaction, which is 45 percent lower than the pre-Durbin average of $0.44.

The Fed’s decision ensured, among other things, that all debit transactions would be processed right at the limit. Now, though for most debit sales the cap meant a reduction in the cost of payment processing, for a significant proportion of the transactions it actually translated into a fee increase.

There are two reasons for that. The first one is that the way the Fed set its limit discriminates against merchants selling low-cost goods. The second is that Visa and MasterCard are no longer willing to give preferential treatment to merchants processing small-ticket transactions. To understand why, you will need to look at the numbers. Let’s do it.

Why Merchants Pay Higher Fees for Small-Ticket Transactions

Well, as it happens, we’ve already done that, which makes my job is a little easier. Before I do some copying and pasting, however, you will need to understand how the new debit interchange structure differs from the one it replaced.

Under the new rules, issuers can charge up to $0.21 per debit transaction plus 0.05% of the sale’s amount and an additional $0.01 can be tacked on for fraud prevention measures implemented by the bank. The per-transaction portion of the new interchange rate is substantially higher than the corresponding part of the old one. For example, the old interchange rate for small-ticket Visa debit transactions – the Visa CPS / Small Ticket, Debit – was 1.55% + $0.04. Here is how the two rate structures compare for transactions in amounts of $5, $10, $15, $20 and $25:

As you see, and as small-ticket merchants are now discovering, the old structure was much more beneficial for sellers of low-cost goods, with the difference growing exponentially with the lowering of the transaction amount. When you go into coffee shop territory – an owner of one is the protagonist of Sidel’s story – that difference can be as high as 100 percent (reached at a hair under $5) or greater. And if you think that such small-ticket transactions are exceptional, here is another piece of statistics for you. In 2009, U.S. merchants processed a total of 4.9 billion debit transactions in amounts lower than $5, according to Federal Reserve data.

The Takeaway

So we knew what the consequences of the new interchange structure would be on small-ticket transactions and warned about it, as did others. This is not difficult stuff, it only takes you a few minutes looking at the numbers to figure it out.

Yet, the amazing thing is that people just refuse to see the obvious. We keep being told in comments and emails that the banks should be made to accept the losses and move on without making much fuss. Now, whether that is the right thing to do in a free and open economy is an important question on which we may agree or disagree, but it is also an irrelevant one.

The point is that, whether anyone likes it or not, the issuers cannot and will not accept the losses and move on. Instead, they will look for and find ways to make up for lost interchange revenues. Someone will always be paying for this revenue-generating exercise. In this case, it is the small-ticket merchant. In most cases it will be the consumer. At the end, when it’s all said and done, the Durbin Amendment will have hugely benefited big-box retailers, the issuers will not be worse off than before the reform and consumers will end up footing most of the bill.

Image credit: Daily Trojan.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

The Financial Services Roundtable has published a fact sheet that lists the results of several studies into the impact on consumers of the Durbin Amendment that went into effect in the beginning of October.

While the FSR, a body representing 100 large financial services companies, clearly has a stake in the game, the numbers it is reporting are fairly uncontroversial and, unless you’ve been living under a rock in the past few months, you should have noticed that banks have been testing various strategies for making up for lost interchange revenues. While some of them have backfired and have been abandoned, most prominently the ill-conceived debit card fee tested by most large banks, other and less conspicuous fees have proved more resilient and are now here to stay.

Sen. Durbin and others may argue all they want that banks have no right to even try to recoup their interchange losses, but in reality they are trying just that and eventually will succeed in doing it. And it all started with the senator’s amendment.

How the Durbin Amendment Is Impacting Consumers

Here is what the FSR’s report says:

FACT: Most merchants will see substantial debit fee savings as a result of the Durbin Amendment. TSG Metrics Survey, October 14, 2011.

FACT: The average savings per merchant is $260.24 for every $100,000 of signature debit and credit card volume processed. Heartland Payment Systems Survey, October 28, 2011.

• Washington DC merchants received the highest average savings of $333.94.

FACT: There is no legal requirement for merchants to pass on savings from the Durbin Amendment to consumers.

FACT: In fact, 41% of merchants reported they do not intend to pass on lower debit card costs to consumers, when asked about the Durbin Amendment. DRF Survey, September 1, 2011.

• 56% of merchants in the survey reported they don’t know yet what they will do.

FACT: There is currently no published research showing that consumers have seen reduced fees at stores as a result of the Durbin Amendment.

FACT: Additionally, consumers are facing higher bank fees, according to the 2011 Bankrate Checking Survey. Bankrate Checking Survey, 2011.

• Just 45 percent of noninterest checking accounts are free of maintenance charges, down from 65 percent in 2010 and 76 percent in 2009.
• “The entire model of free checking has been turned upside down because of <Regulation E and the Durbin Amendment>,” said Ajay Nagarkatte, managing director of Chicago-based BAI Research, in the Bankrate survey.

There it is. It is clear (as it always has been to those who were paying attention) who is benefiting from the legislation and who isn’t.

How Banks Cope with the Durbin Amendment Effects

While the various debit card fees tested by Bank of America, Wells Fargo, Chase and other big banks have been getting the most attention, they are just one piece of the banks’ strategies for dealing with the Durbin Amendment’s revenue-slashing effects. These fees were eventually abandoned and the banks no doubt regret having ever decided to test them, but many other components of their strategies are very much alive.

Banking is still becoming more expensive, debit card fees or not. As the FSR study shows, free checking is quickly disappearing and other banking fees are creeping in, as the NYT recently reported.

At the same time banks are pushing hard to drive customers away from far less profitable debit cards and toward credit and prepaid cards, which were unaffected by the interchange reform. To that end, credit card offers are rapidly increasing in number, terms are improving and rewards programs are becoming ever more generous.

Prepaid cards were already the fastest-growing non-cash payment type in the U.S. even before the reform and now that bigger issuers are becoming more interested in them, their growth will accelerate further. American Express showed us what the future of prepaid will look like when it launched its fee-free card a few months ago.

The Takeaway

As we’ve been arguing on this blog all along, when it’s all said and done, the upshot of Sen. Durbin’s amendment will be that merchants will have increased their revenues, compared to the period before the reform took hold, banks will at worst be revenue-neutral and consumers’ cost of banking will have risen.

Yet, while on average consumers will be worse off, some will actually benefit from the better rewards programs and prepaid cards on offer. Unfortunately, the good rewards programs are only available to consumers with higher incomes and higher credit scores and prepaid cards are not yet, and are unlikely to ever be, nearly as widely used as needed to make a difference. So at the end those who will end up footing Sen. Durbin’s bill will be the ones who can least afford it.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).

The government is once again attempting to simplify credit card agreements, various news outlets are reporting this morning. This time the agency in charge of the project is the recently founded U.S. Consumer Financial Protection Bureau (CFPB).

You may remember that not too long ago, Congress itself passed the CARD Act, which was intended to protect consumers against unfair practices employed by credit card companies. Prominent among the act’s provisions were mandates for clear and easy-to-understand disclosures of the terms of agreement, which were supposed to eliminate confusion among consumers. Now the CFPB is trying to achieve exactly the same objective all over again.

CFPB’s Goal: Short, Simple Credit Card Agreements

Bloomberg has a reference to a “prototype” of CFPB’s vision for the ideal credit card agreement, but the link is broken and I have not been able to locate the document on CFPB’s website. So I’m relying on Bloomberg’s description:

The standardized, two-page card agreement outlines prices, risks and terms that are shorter and more concise than conventional agreements, augmented by an online glossary to aid consumers on such items as billing disputes, privacy, rights, interest-rate calculations and the consequences of late payments.

What this new agreement template is expected to achieve is summarized by Raj Date, a special adviser to the Secretary of the Treasury, as quoted in Bloomberg’s piece:

Credit cards can be complicated… With a short, simple, easy-to-understand credit card agreement, consumers can clearly see the terms of the deal and make decisions that are right for them.

Well, as I said, the CARD Act was supposed to achieve precisely that.

CARD Act on Credit Card Agreements

Let’s take a look the part of the act dealing with credit card agreements:

Plain Sight / Plain Language Disclosures: Credit card contract terms will be disclosed in language that consumers can see and understand so they can avoid unnecessary costs and manage their finances.

• Plain Language in Plain Sight:  Creditors will give consumers clear disclosures of account terms before consumers open an account, and clear statements of the activity on consumers’ accounts afterwards.  For example, pre-opening disclosures will highlight fees consumers may be charged and periodic statements will conspicuously display fees they have paid in the current month and the year to date as well as the reasons for those fees.  These disclosures will help consumers make informed choices about using the right financial products and managing their own financial needs.  Model disclosures will be updated regularly based on reviews of the market, empirical research, and testing with consumers to ensure that disclosures remain clear, useful, and relevant.
• Real Information about the Financial Consequences of Decisions: Issuers will be required to show the consequences to consumers of their credit decisions.
  • Issuers will need to display on periodic statements how long it would take to pay off the existing balance – and the total interest cost – if the consumer paid only the minimum due.
  • Issuers will also have to display the payment amount and total interest cost to pay off the existing balance in 36 months.

Additionally, the act required issuers to post credit card agreements on the internet, so that both consumers and regulators would have an easy access to them. So what was the effect of these changes? Let’s look at CFPB’s own assessment.

CFPB on CARD Act’s Effect on Credit Card Agreements

Here is how the CFPB assessed the Act’s success at clarifying credit card terms and conditions for consumers:

• 80 percent of cardholders have noticed that their payments are now due on the same day of each month
• 77 percent have noticed that the monthly statements contain a warning about the cost of making a late payment
• 70 percent of cardholders have noticed that monthly statements now contain information about the consequences of making only minimum payments
• 48 percent of consumers recall that their bill now tells them how much to pay each month in order to pay off the balance within three years
• 31 percent of cardholders who recall seeing the new information on their statement report that this information has caused them either to increase the payments they make or to reduce their use of credit.
• Of the cardholders who have noticed at least one of the changes in their monthly billing statements, 60 percent say that their monthly statements are easier to read and understand than they were a year ago.  Additionally, 60 percent say that the terms of their credit card are clearer than they used to be.
• At the same time, 32 percent of those who carry a balance from month to month say they do not know how much interest they paid on their primary credit card last year.

This sounds to me like a fairly positive evaluation. Fully 60 percent of consumers already find the agreements both easier to read and more clear. Considering that a substantial number of consumers will not have read their agreements to begin with, two of Mr. Date’s objectives seem to have been achieved quite successfully by the CARD Act.

What about helping consumers understand the meaning of terms like “billing disputes, privacy, rights, interest-rate calculations and the consequences of late payments?” Well, isn’t it obvious what a billing dispute is? I mean, what is there to be clarified? And isn’t it equally obvious that payments should be made on time and that the consequences of not doing it would be unpleasant? Not to mention that these consequences are already prominently disclosed in each agreement in the form of a late payment fee and that the CFPB’s own assessment states that 77 percent of consumers are aware of them.

Regarding privacy and rights, these terms need no explanation, but a disclosure and have already been heavily regulated in the CARD Act and other legislations. Finally, interest rate calculations can indeed be difficult to understand for everyone and I don’t think that any amount of explanation can change that fact. However, that does not mean that consumers are not protected against high interest rates. For example, the CARD Act banned retroactive interest rate hikes, required a clear disclosure of any promotional rates, gave consumers the right to close an account, with no negative consequences, if they did not agree with a proposed rate increase, put a stop to the practice of “universal default,” etc.

The Takeaway

The way I see it, what the CFPB is attempting to do with credit card agreements has already been achieved quite successfully by the CARD Act, even by the CFPB’s own assessment. I have no idea why the agency has taken up this task, but I think that it is wasting government resources.

Image credit: LoveToKnow.

Learn how to lower your card acceptance cost

Learn how to accept credit and debit cards at the lowest processing costs. The Payment Card Acceptance kit contains a video and an e-book:

• Video – Card Acceptance Best Practices for Lowest Processing Costs (18 min).
• E-Book – Payment Card Acceptance Guide (19 pages).