How new regulations saved consumers billions in credit card fees

Millions of Americans, particularly those with modest incomes or those who are just starting out, struggle with their credit cards. My wife and I often had high balances when we lived on one modest income and had two kids in day care. My students often face similar issues. More than a few choose not to reveal their monthly credit card bill to their live-in romantic partners.

My favorite finance paper published last year makes clear that struggling with credit cards is not unusual. The study examined 2008–2012 data from a mammoth database of 160 million credit card accounts at America’s eight largest banks to analyze the practical impact of the Credit Card Accountability Responsibility and Disclosure (CARD) Act, which Congress passed in 2009. The authors found that the CARD Act was a triumph of financial regulation.

“The CARD Act did two main things,” according to Neale Mahoney, a co-author of the study and my cross-campus colleague at the University of Chicago. “First, it restricted a number of credit card fees. Second, it required credit card issuers to provide information on annual statements that was designed to ‘nudge’ consumers into making larger monthly payments on their cards.”

Mahoney and his co-authors found that the legislation saved consumers $11.9 billion per year, largely by reducing fees imposed on the least sophisticated consumers who have the lowest credit scores.

And unlike other sorts of credit regulation, the CARD Act seems to have produced few offsetting unintended consequences. “We don’t find any evidence that card issuers offset the reduced fee revenue by increasing interest rates (or other fees not targeted by the law) or by reducing access to credit,” Mahoney told me.

Most of the savings came from eliminating fees credit card companies used to charge when customers went over their credit limits.

The paper provides a fascinating look at the business models that underlie the credit card industry. You might expect that credit issuers make the most money from people who are the most financially stable and pose the lowest risks. In reality, credit card issuers make the largest profit margins on consumers with the worst credit (FICO) scores.

The first bar graph below, drawn from the paper, shows the basic pattern. The blue bars show the profits realized by credit card issuers as a proportion of average daily balances (ADB). Customers with FICO scores below 620 — 17 percent of all accounts — realized impressive net profits of about 7.9 percent of ADB. Profit margins were far smaller, and are sometimes negative, for some other classes of consumers.

Not surprisingly, consumers with the lowest credit scores were most likely to default. Yet credit card companies were able to more than make up for this statistical risk by charging high interest rates and — especially — high fees such as those imposed on late or missed payments, or penalties imposed when people exceed their maximum credit limits. The green bars show fee payments, which are markedly larger than even interest charges for consumers with the weakest credit.

Indeed, what most strikes me is that the burden of various fees falls so heavily on people with poor credit scores, and are a pretty minor nuisance for everyone else. Fees exceed 30 percent of ADB for every FICO category below 560, compared with about 3 percent for accounts with FICO scores above 700 — roughly the top half of the distribution.

Credit card company profits don’t come entirely from high-risk customers, however.

“Credit card companies also make sizable profits from consumers with the best credit scores, who generate a lot of ‘swipe fee’ revenue” — that is, fees charged to merchants at the time customers make purchases, Mahoney said. According to him, “Consumers with average credit scores — who are better at avoiding fees, but don’t spend a large amount — are still profitable, but less so than high and low credit score consumers.”

While the business models of credit card companies can be complicated, Mahoney says the lesson for consumers to draw is simple.

“Pay off all your credit cards in full every month,” Mahoney told me. “If you can’t pay off all your cards, pay as much as you can on the card with the highest interest rate, and make the minimum payments on the others.”

If you can do that consistently, you’ll be doing better than most American consumers, Mahoney said. “Thirty percent of account holders pay off their bill in full. At the other extreme, 13 percent of borrowers only make the minimum payment, and 15 percent make payments of less than the minimum amount.”

Mahoney also warned consumers to be wary of those “teaser” rates that offer zero percent interest for an introductory period such as 12 or 18 months.

“Obviously some people manage to transfer their balances when the introductory rate period expires, and these cards are a good deal for these consumers,” he said. “But the reason credit card issuers promote these products is that some people (either because of bad luck or bad planning) don’t transfer their balances and end up paying large amounts in interest.”

Mahoney believes this could be an area for regulators to look at in the future. “I’m not sure if we want a product that is based on taking advantage of bad luck or bad planning to play such an important role in the market,” he said.

Harold Pollack teaches social service administration at the University of Chicago. He is co-author with Helaine Olen of the new book The Index Card: Why Personal Finance Doesn’t Have to Be Complicated