Widening interest spreads are increasing the cost of bad credit

Richard Barrington
Written by
Richard Barrington
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Interest rates became a hot discussion as 2023 drew to a close. After a sustained run of eleven interest rate hikes totaling 5.25%, the Federal Reserve signaled its intent to begin lowering rates in 2024.

If you assume this means you can look forward to cheaper credit this year, you may be disappointed. Even once the Fed starts lowering interest rates – which depends on inflation continuing to weaken – some consumers may not see any impact on the rates they pay.

In fact, if recent trends continue, some credit card customers may even see their rates move higher.

Doesn’t the Federal Reserve set interest rates?

Though the Fed is often portrayed as having absolute control over the interest rates consumers pay, the reality isn’t that simple.

The Fed sets rates that are widely used by banks to borrow money for liquidity purposes. These rates are a cost that banks and other lenders pass along to consumers, but they are not the only cost.

Think of this as somewhat like the way the price of steel impacts auto manufacturers. If the price of steel goes up sharply, it is likely to affect the price of cars. However, steel is far from the only cost that goes into a vehicle, so auto prices don’t move completely in lockstep with the price of steel.

Similarly, when they issue credit cards, banks have other costs to cover besides the interest they have to pay for operating money. One of these is the cost of customers who don’t pay their bills on time.

This cost is rising, and that may have the greatest impact on credit card customers with low credit scores.

What are interest rate spreads?

Many credit cards advertise themselves using a range of interest rates. For example, a card might advertise rates ranging from 19.99% to 29.99%.

This range is known as an interest rate spread. That spread measures the difference between rates charged to customers with excellent credit, and those charged to customers with weaker credit.

When credit conditions are generally good, it means the number of borrowers who are missing payments is relatively low. At such times, credit card companies are more willing to take on customers who don’t have great credit histories. As a result, the interest rate spreads charged by credit card companies can be relatively narrow.

However, when credit conditions worsen, credit card companies become especially wary of customers with lower credit scores. If they accept those customers, they are likely to charge them elevated interest rates. This causes interest rate spreads to widen.

Wider credit spreads mean customers with weak credit pay much more than those with strong credit. People with low credit scores may even see their rates rise while rates generally are holding steady or going down.

How interest rate spreads have widened over time

Credit card rate data from the Federal Reserve provides some insight into the rate spread trends. The Fed reports the average of both the stated interest rates on credit cards and the rates actually charged on credit card balances. Since customers who carry balances tend to have lower credit scores than those who do not, the differences between these two averages suggest whether interest rate spreads are widening or narrowing.

Early in 2023, the spread between these interest rates was just 0.83%. Just six months later it almost doubled, to 1.58%.

Under any circumstances, people with poor credit can expect to pay more for their credit cards than people with excellent credit. If the trend towards widening interest rate spreads continues, people with poor credit can expect this extra cost to get even steeper.

Why are interest rate spreads on credit cards getting wider?

What happened during 2023 that could have caused this interest rate spread to get wider?

A likely cause was that credit risk increased. More credit card customers fell behind on their payments. In particular, people with poor credit were especially likely to have overdue accounts.

According to the TransUnion Credit Industry Snapshot for November, serious delinquency rates were rising on payments for bankcards, mortgages, auto loans and personal loans. In particular, late payments were up sharply over the prior 12 months for mortgages and bankcards.

Despite this, late payment rates for customers with prime or better credit scores remained fairly low – well below 1% on bankcards. In contrast, late payment rates for subprime customers rose by nearly 1.5% over prior 12 months.

By November, the late payment rate for subprime bankcard customers was 20.79%, compared to just 0.20% for prime customers. Given that difference, it’s easy to understand why lenders would charge more interest to riskier customers. That’s why credit spreads have been getting wider.

How can consumers prevent bad credit from costing them more?

2024 is expected to bring lower interest rates overall, but not necessarily for people with weaker credit scores. Rising delinquency rates may translate into higher interest rates for people with lower scores.

If you want to pay less interest this year than last, here are three strategies you should try:

  1. Work on improving your credit score. In this environment, raising your credit score could really save you money. Concentrate first on making all your payments on time. Then work on borrowing less so your debt utilization ratio comes down.
  2. Reduce credit card balances. This can have both a direct and an indirect impact on the amount of interest you pay. Lowering the balance you owe will directly reduce the amount of interest that’s charged on that balance. In time, reducing the amount you owe should help your credit score and qualify you for lower interest rates.
  3. Shop for better credit card options for your credit score. If you have less-than-perfect credit, you’re not likely to qualify for the best rate a credit card advertises. It’s important to research what rate someone with your credit record will be charged, and choose the credit card that’s least expensive for your situation.

Worsening credit conditions means there could be a higher price to pay for having bad credit in 2024. Not only could credit be harder to get, but it’s likely to cost more when you do get it.

To avoid paying more for bad credit this year, it should help if you reduce your dependence on borrowing, and shop around for cheaper credit cards.

Richard Barrington
Cardratings Contributor

Richard has over 30 years of experience in financial services, including 23 years with the investment management firm Manning & Napier Advisors, Inc., where he led the Marketing Group and served on the firm’s Investment Policy Group and Executive Group. Over the years, Barrington has...Read more

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