Features > January 28, 2008
Killer Credit
Attack of the $915 billion consumer debt monster
By Adam Doster
Candace Angus is not one to break the rules. When she served on the Chicago police force for 25 years, it was her duty to maintain order. And as a longtime credit card user, she was never late on a payment and never in debt. So when she found interest on her Capital One balance considerably higher than she anticipated, she was irked.
A customer service representative explained that the charge was “residual interest” from two months prior that had not yet been applied. Although she didn’t grasp the concept fully, Angus swallowed the news and paid her next bill in full. Thirty days later, residual interest was still on the statement, and higher than the month before. “[Capital One] caught me entirely by surprise,” she says. “I’d never heard of that practice before.”
What was this mysterious charge? Essentially, the payoff balance was obsolete by the time it reached Angus’ mailbox because interest continued to build as her bill slid its way through the mail system. If her check took a week to reach the processing center, seven days worth of interest was eventually tacked on. And this caveat was hidden in the contract’s fine print.
“It should be clear to the consumer that interest is being held up for a few months,” Angus fumes. “Is it to the benefit of the consumer or is it to the benefit of the credit card company?” While she acknowledges that others have it worse than her—because her problem didn’t lead to default or loads of debt—Angus’ experience typifies those of many. “All the cards don’t use that practice,” she says, “but they all catch you somehow.”
In the last quarter century, an unstable financial relationship was forged between Americans—grasping for an increasingly elusive middle-class lifestyle—and credit card companies that offer strapped consumers a lifeboat. But without adequate regulation, the industry has used deceptive techniques to hoodwink consumers and accumulate more than $30 billion in profits per year. Now, if legislators at the national level don’t step in, some analysts fear American’s affection for credit may widen the existing credit crisis.
Bearing the debt burden
First, the facts. Americans own almost 700 million credit cards and hold $915 billion in consumer debt, with the average borrower owing more than $9,000, according to Cardtrak.com, a top financial information website. For a rough comparison, the world’s 54 poorest countries owe a nudge under $400 billion in total foreign debt. In 1970, 49 percent of Americans didn’t have a credit card. Today, only 7 percent don’t.
Coinciding with this rapid growth, the Supreme Court ruled in 1978 that banks could charge the maximum interest rate determined by state legislatures in the banks’ home states, not the interest rate of the states in which they do business. Unsurprisingly, credit card businesses moved to Delaware and South Dakota—two states with virtually no interest caps—thus rendering state usury laws worthless.
Twelve years ago, the court applied the same logic to the size of fees a bank can charge. Congress has refused to step in at the federal level, enabling the industry’s thorough deregulation.
With the freedom to act on their own accord, banks have implemented an array of confusing and punitive measures that bilk cash from clients.
“It’s pretty extraordinary to see how the industry has essentially created a diluted regulatory environment, where they can basically do what they want to consumers,” says Robert Manning, author of Credit Card Nation and a professor of finance at the Rochester Institute of Technology.
Before the ’90s, most credit cards had one annual fee and a fixed rate. Today, they carry an assortment of charges that oscillate with the market and the cardholder’s credit risk. If a borrower overdraws, instead of just declining the transaction from the outset, companies tack on a fee of $30 or more, on top of a 29.99 percent penalty rate on interest. If a payment is missed, an average late fee of $34 is levied. That’s a $21 hike since 1995, according to a 2006 Government Accountability Office report.
Late fees are endless, as well. Banks charge the borrower until he or she breaks, as opposed to canceling a delinquent card, which was once an established procedure. Vanity is the banks’ justification, claiming the practice allows customers to evade the humiliation of rejection.
Universal default is another vicious innovation. If applied, one lender can raise the terms of a loan to the default rate (27 percent, on average) when a customer fails to pay another lender, even if the customer’s record is perfect with the original bank. In theory, a technical error or fraud could trigger rate hikes on every card someone owns, a scary thought considering the average American has seven credit cards in his or her wallet. Roughly half of the banks that issue credit cards have universal default language in their contracts.
For people with substandard credit scores or limited credit histories, often low-income people of color, intensely marketed subprime or “fee-harvester” cards present a huge danger. These carry substantially higher interest rates and lower credit limits than cards granted to prime borrowers, and are laden with fees. In fact, it’s possible for subprime fees to absorb a borrower’s entire limit, leaving him or her with nothing to spend.
“The issue is how you make credit card loans to people with bad credit, and how you make money off of that,” says Jim Campen, executive director of Americans for Fairness in Lending (AFFIL). “And the solution is basically, give them a credit card but don’t give them credit, and charge them a lot of fees for doing it.”
Even highly responsible customers are at risk. In some circumstances, borrowers are subject to retroactive price hikes, meaning banks can enforce higher rates on old balances as well as new ones, even if none of the original payments were late. Two-cycle billing, a practice some banks use, calculates interest payments based on the average daily balance over two billing cycles as opposed to one, harming borrowers with divergent monthly balances, even if they pay promptly.
And the list goes on.
While it’s unlikely that sensible consumers would ever agree to these outrageous terms, many opt in unknowingly. In 2004, the Wall Street Journal found that a standard contract in the ’80s was one-page long. But weak disclosure requirements now allow banks to dole out 30-page contracts in six-point font, often burying important stipulations, such as nonbinding legal arbitration, or omitting basic terms of credit.
Consumer advocates like Campen argue that credit card companies are counting on people to misunderstand the total cost of swiping a card. “[The contracts] are hard to understand if you do read them,” he says. “You don’t know at the time … that you’re signing your rights away.”
Angus agrees. “Once you start getting a little risky, a little in debt … they treat you completely differently,” she says. “It’s like they want to push you into dangerous waters.”
And it has worked. Exploiting this asymmetry of information, credit card companies have reaped enormous earnings. R.K. Hammer, a California firm that evaluates credit card portfolios, found that the industry raked in $36.8 billion in net pretax profits during 2006. Meanwhile, credit card debt has more than tripled since 1990.
Plastic safeguard
If credit cards are a trap, why don’t people abandon them entirely? Because, experts say, people must have their basic needs met, which credit cards make possible.
“The perception … is that credit cards are used for frivolous spending, that it’s just easy money for people to use to buy their nice sneakers,” says José Garcia, a senior researcher at the think tank Demos and author of a new study called “Borrowing to Make Ends Meet.” “But they’re not seen as a way that people have been dealing with economic shock.”
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