A credit card rate cap could shut millions out of credit

Richard Barrington
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Richard Barrington
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A credit card rate cap could shut millions out of credit
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The federal government recently approved a plan to limit the dollar amount credit card companies can charge as late fees.

The next target? Credit card interest rates.

Rising credit card interest rates have drawn the attention of both regulators and politicians. Is a limit on credit card interest rates a possible response? And, if it happened, would it really be good for consumers?

Bipartisan support for a credit card rate cap

Last September, Republican Josh Hawley, a U.S. Senator from Missouri, introduced a bill that would cap credit card rates at 18%.

A few years earlier, Independent Bernie Sanders, a U.S. Senator from Vermont, introduced a proposal calling for an even lower rate cap. Democrat Alexandria Ocasio-Cortez, a U.S. Representative from New York, joined him in making the proposal.

This type of legislation is given little chance of passing. However, if senators from both sides of the aisle are calling for it, that suggests a pretty broad base of support.

Are credit card companies price gouging?

The premise behind these proposals is that credit card companies are charging unnecessarily high rates at the expense of American consumers.

What evidence is there that credit card companies are price gouging? On the surface, there are reasons to believe that frustration with credit card rates is justified.

Since 2020, the average rate charged on credit cards has risen by 6.47%. Over the same period, the Federal Reserve has raised interest rates by 5.25%. This suggests that while interest rates in general have been rising in recent years, credit card companies have taken advantage of the situation by raising their rates even more.

This impression is reinforced by a recent report from the Consumer Financial Protection Bureau (CFPB). The CFPB studied the APR margin on credit cards. This is the amount credit cards are charging over and above the national prime interest rate.

The report found that the APR margin on credit cards has never been higher. One way to look at this is that credit card companies are charging interest rates above what should be normal for today’s market.

For example, ten years ago the prime rate was 3.3%, and the average credit card interest rate was 12.9%. That made credit card rates 9.6% higher than the prime rate. In other words, 9.6% was the average APR margin at that time.

Last year, the prime rate was 8.5% while the average credit card rate was 22.8%. That meant the average APR margin was 14.3%.

With the APR margin on credit cards having swollen from 9.6% to 14.3%, it’s easy to see how some people might get the impression that credit card companies are pocketing a lot of extra interest these days. However, the APR margin doesn’t tell the full story.

Credit card risk levels tell a different story

The other part of the story behind credit card interest rates involves risk.

The prime rate is the interest rate banks charge their most creditworthy customers. In reality though, banks issue credit cards to people with a range of different credit histories, from bad to good.

This matters, because credit cards need to charge extra interest to customers whose credit is less than perfect. This protects the credit card issuer from the reality that a higher percentage of these customers are likely to miss a payment or default on their debt altogether.

How big of a risk is this?

According to TransUnion, one of the three major credit bureaus, as of January of 2024 just 0.21% of credit card customers with prime credit scores were 90 days or more late on credit card payments. In contrast, 21.22% of subprime credit card accounts had payments that were 90 days late or more.

By this measure, the risk of subprime customers is 100 times greater the risk of prime customers. Recognizing this elevated risk makes it easier to understand why credit card companies might charge higher rates to customers with lower credit scores.

By the same logic, when late payment rates are rising, or when a credit card company chooses to accept more subprime customers, it makes sense that their interest rate may rise more quickly than the prime rate.

Rate caps could reduce access to credit – is that a bad thing?

This doesn’t mean the risk of missed payments totally explains today’s credit card rates. However, it does show why a cap on credit card rates might not work.

For example, if credit card rates were capped at 18%, credit card companies would be unlikely to take on subprime customers. After all, when 21% of these customers are seriously late on their payments, the credit card company would be earning less interest than the amount of overdue payments.

So rate caps would be very likely to restrict access to credit among customers with lower credit scores. This would almost certainly prompt outrage from some consumer advocates. But would preventing people with lower credit scores from getting credit cards be such a bad thing?

After all, these customers pay the highest interest rates. They are also most likely to struggle to make their payments. An argument could be made that many subprime customers would be better off without a credit card.

However, that argument ignores the fact that most subprime customers make their payments and use credit responsibly. Why should these customers be denied the opportunity to borrow money and build a better credit history?

It’s not an easy question to resolve. However, while a proposal like an interest rate cap has popular appeal, it’s a solution that would only cause other problems.

Three ways you can pay less interest without legislation

Instead of waiting to see if politicians or regulators can reduce what you pay in credit card interest, there are three steps you can take yourself:

1. Improve your credit score. People with lower credit scores pay higher interest rates. The work you put in to improve your credit score should pay off by getting you a better deal.

2. Shop around. Credit card rates vary by issuer. Shop around whenever you’re choosing a credit card. Even when you aren’t looking for a new card, shop around now and then to make sure the rates on your existing cards are competitive.

3. Keep your balance as close to zero as possible. Interest rates don’t affect those who pay their balances off every month. Make it a practice to always pay more than the minimum amount due, and whenever possible pay your balance off in full to avoid interest charges.

Fair or not, credit card interest rates are high. Taking the above steps can help you minimize the impact of those high rates on your budget.

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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