Americans have come to rely on their credit cards as both a form of payment for purchases and a flexible way to borrow cash. The total amount of credit card debt is approaching a trillion dollars. Credit cards are a key source of revenue for financial institutions and usually among the most profitable loan products available today.
Credit card pricing has become highly complex and increasingly difficult for borrowers to follow. Credit card issuers at one time charged a single fixed interest rate to all customers and now charge individual customers several different varying interest rates at once, some of which expire after a short time period, and some rates suddenly changing to "penalty rates" under certain conditions. The number and importance of fees charged to consumers has also grown dramatically.
While there has been significant public discussion of certain hidden fees that are common on credit cards, manipulating how consumers' payments are allocated towards a borrower's balance is another hidden charge that can impose significant costs on the borrower without their knowledge. Borrowers can have balances on the same card at several different rates at once such as a purchase balance, a temporary promotional – or "teaser" – balance and a high-rate cash advance balance. By putting all of the payment toward the lowest rate balance (typically the purchase balance or teaser balance), issuers can in effect substantially raise the interest rates paid by borrowers.
This report demonstrates that this ordering of payments or "payment allocation" policy can be both expensive and confusing for credit card customers who, as a group, have little knowledge of the mechanics or cost. The data analyzed in this report shows that allocating payments to the lowest rate first is harmful to borrowers, highly deceptive, and inconsistent with risk-based pricing. More specifically the study finds the system is stacked against borrowers in the following ways:
- Payment allocation forces borrowers to pay the highest prices, as much as 7 percentage points higher. By paying the lower-cost purchase balance first, payment allocation increases the borrower's other balances and effectively raises the total interest paid by the borrower. As a result of payment allocation abuses, some borrowers with credit card debt pay as much as $700 extra each year.
- Customers are unaware of the significance and impact of these hidden charges. Only 3% of borrowers surveyed have the knowledge and capacity to evaluate credit card companies' payment allocation policies.
- Payment allocation distorts risk-based pricing. When all measures of risk are taken into account, our analysis reveals the opposite of risk-based pricing. Lower risk customers pay significantly higher interest rates compared to high-risk borrowers.
It is understandable that credit card issuers may sometimes need to raise prices to manage risk. However, when they do, their approach should be transparent and should allow markets to remain efficient. Manipulating where payments are allocated amounts to hidden and deceptive pricing that penalizes lower-risk borrowers and only exists because it is not understood by borrowers.
Due to a borrower's general lack of knowledge and the complexity of payment allocation policy's impact, disclosure is an inadequate solution. Proposed regulations under consideration by federal financial regulators would prohibit the use of the lowest rate first method, which is the most costly to consumers. By requiring issuers to choose among three other allocation options, the proposal represents a potential improvement that would take less advantage of consumers and improve risk-based pricing. However, the concept of consumer choice is meaningless because the evidence strongly indicates that people do not have the information or understanding necessary to choose among issuers with different policies, if major issuers do in fact vary in payment policy in the future. Therefore the optimal public policy would select a single policy and make it uniform throughout the industry. Specifically paying the highest rate first is the optimal policy since it saves consumers the most money and is the most consistent with risk-based pricing.