Respond to this Article December 2005

Taking Charge

Attention credit card companies: When we want you to charge us hidden fees, we'll let you know.

By Robert Gordon and Derek Douglas

In 1949, a finance executive named Frank McNamara invited two friends to dinner at Major's Cabin Grill in New York City. At the end of the meal, McNamara found that he had forgotten his wallet, and he was forced to call his wife for money. McNamara vowed never to face that humiliation again. He made good on the vow: A year later, he returned to Major's and this time paid the bill with a new product--a small piece of cardboard.

Thus was born Diners Club, the world's first credit card. Within a year, 20,000 such cards were in circulation throughout the country; today, there are 1.5 billion--five for every American man, woman, and child. What in McNamara's day was a convenience that allowed the rich to dine out without cash is now a staple of middle-class life.

Credit cards have proliferated for many reasons. Some are economic: At a time when average earnings are stagnant, when sudden income drops because of layoffs or health problems are common, and when public and private insurance systems have frayed, families increasingly turn to credit cards to serve as their financial safety net. The growing reliance on plastic is also about culture: Americans love freedom. Just as the invention of the mass-produced automobile gave us the freedom to travel wherever or whenever we wished, credit cards allow us to spend money in ways and at times that work for us.

These freedoms, however, make both cars and credit cards dangerous if they are used improperly. The difference is that in the past 40 years, we've taken steps to make automobiles safer. As cars became an integral part of middle-class life, traffic fatalities rose sharply. In the 1960s, thanks largely to the efforts of consumer advocates, Congress passed landmark safety legislation that led to mandatory seatbelts and rear-window brakes lights. The new rules reduced accident rates and made those crashes that did occur less deadly (the auto fatality rate has dropped 57 percent since 1966).

While cars continue to become safer, credit cards are becoming more dangerous. Of course, cards don't kill, but they threaten families in other ways. Credit-card debt totaled $685 billion last year, and the problem is getting worse: In the last decade, credit-card debt rose by about 70 percent. Although economists debate whether rising costs or rising consumption have contributed more to that trend, there is no question that most Americans experience the debt as a burden. Seventy percent of American families said last year that they are carrying so much debt that it is making their family lives unhappy; three times more young people are worried about going deeply into debt than about a terrorist attack.

Credit cards are especially dangerous because of the business practices of credit-card companies. Buried in those offers you receive daily in the mail are fine-print contract terms not subject to negotiation. Cardholders who miss a single payment may be hit with two separate charges: a $39 fee and a penalty interest rate of 29.99 percent or higher. Those who mistakenly go over their credit limit no longer have their cards declined. Their purchase is charged, along with a $35 fee and--you guessed it--the 29.99 percent penalty rate. These fees can quickly double or triple the underlying debt on the card. Perhaps most egregiously, even families who pay their bills on time can be hit with penalty rates. Under a practice known as "universal default," companies can raise rates based on a change in a customer's credit score, a dispute he has with another creditor, or even a purchase he makes that they don't like. These new rates apply even to old credit, so if you bought a washer and dryer and new clothes for the kids, all at 7.99 percent interest, you can get socked with a 29.99 percent rate--even if you have made every payment on time.

Practices such as these are great for the industry's bottom line. From 1996 to 2003, the money credit-card companies make from fees has more than quadrupled, to $7.7 billion. Families aren't making out quite as well. Penalty fees and interest combined now cost average credit-card holding households more than $800 each year. All told, Americans cough up about $90 billion annually in interest and penalty payments on credit cards. That's $90 billion that could have gone into car repairs or college tuition or savings accounts--and ends up in company bottom lines instead.

For families with adequate incomes, that $39 fee may be just an annoyance. For families on the edge, a cascade of penalties and fees can mean economic ruin. Both in the United States and abroad, there is a clear correlation between rising credit-card use and increasing rates of bankruptcy. At a time when more Americans have no choice but to depend on consumer credit, more families find their cards offer no safety net at all--they are instead, in the words of Harvard law professor Elizabeth Warren, a cement life raft.

Stable families shouldn't be slammed by fees they had no reason to expect. And struggling families shouldn't be getting pushed into bankruptcy by companies purporting to offer them a solution to their problems. This doesn't mean we should take credit cards away from borrowers, any more than the consumer safety movement meant taking cars away from drivers. But it does mean that we need to make credit cards safer to use, with measures that honor Americans' freedom but empower them to protect their own financial interests.

Read the fine print

For much of American history, most states had laws that effectively capped interest rates. In 1978, however, the Supreme Court ruled that an obscure 1863 law allowed banks to charge up to the maximum interest rate stipulated by the legislature in their home state, not the interest rate of the states in which they do business. Predictably, credit-card operations quickly relocated to states such as Delaware and South Dakota that do not regulate interest rates. Nearly 20 years later, in 1996, the Court applied the same logic to credit-card fees. Credit cards were effectively deregulated.

All that remains of consumer credit protection today are weak disclosure requirements. Companies must include a box on all bills with key rate and fee information. But these details are confusing even to lawyers: A typical MBNA disclosure box contains 18 different Annual Percentage Rates (APRs). And some critical information doesn't even have to be put in the box. Consider Chase's breathtaking assertion that "we reserve the right to change the terms of your account (including the APRs) at any time, for any reason." It's buried in small print on the back of a form.

In addition, companies are not required to disclose basic terms of credit, such as how much time and money a customer will have to spend in order to pay a bill if they make the minimum payment. Car companies and mortgage lenders give customers this information, but credit-card companies have fought to make sure that they don't have to.

This refusal to disclose basic information takes advantage of something credit-card companies know about human nature. As New York University's Oren Bar-Gill has explained, consumers systemically underestimate their own borrowing demands, and then overestimate the likelihood that they will pay off their cards. This explains why they are drawn to the zero percent teaser rate while dismissing the threat of the 29.99 percent penalty down the road. With the steadily escalating pace of modern life, most consumers also have little time to devote to personal finance. That's one reason why tens of millions of Americans carry high-interest debt on their credit cards, even though they have real money in checking accounts.

All of this figures directly into the credit-card issuers' business plans. Companies expect that many customers will fail to meet payment deadlines, so they encourage heavy initial borrowing--No annual fee! Zero interest for 90 days!--and then, under terms buried in fine print, collect huge sums when the cardholder misses a payment, goes over her limit, or carries a balance. As Andrew Kahr, a consultant to the credit-card industry, notes, companies view those who fail to pay in full and on time not as delinquents, but as profit sources.

Yes, please, I would like triple interest

A traditional liberal approach to this crisis of credit would be to restore limits on interest rates and fees, knowing that banks would respond by cutting off card offers to many Americans. But the goal should not be to save consumers from themselves by making it impossible for them to get credit cards. It should be to give consumers the means to manage their credit wisely, and to reset the entire system so that consumers don't have to go out of their way to avoid being fleeced. Americans need more than the freedom to follow their worst instincts into bankruptcy. They need the information and tools to make the best choices for themselves.

Congress should enact a "Credit Card Users' Bill of Rights" designed around two basic principles. First, when busy Americans sign on the dotted line and get their new cards, the fundamental rules should work for them, and not just for the companies. Second, consumers should have access to all the information they need--and in the form they need it--to make wise long-term decisions for themselves. What they choose to do with that information is up to them.

The benefits of this first principle can be clearly seen by considering another financial instrument: tax-free 401(k)s. Worker participation in 401(k) plans is notoriously low, even for those who have private, taxed savings elsewhere. That is largely because people don't like the hassle of signing up for this type of plan. But when companies simply change the default rule--automatically enrolling employees into 401(k)s, with the opportunity to opt out if they want--participation rises dramatically. A smart pro-savings policy, as advocated by the Brookings Institution's Peter Orszag, would shift employer-sponsored savings plans from "opt-in" to "opt-out" across America.

Much as families don't engage in tax-free saving that would benefit them financially, they also carry costly balances on their credit cards even when they have money sitting in a checking account. Here, too, the way to reduce the waste is to reduce the hassle. When signing up for a card, companies should be required to have a policy of linking their customers' credit cards to their checking accounts. Those accounts would be set up to make automatic regular payments--the full bill, a minimum payment, or some amount in between. Customers could choose to opt out of the system or to override the payment in a given month, and some would. But a customer's bill would be paid automatically unless she requested otherwise. Such a system would significantly reduce the chance of incurring late fees or higher interest. In Japan, where a similar practice is in place, consumers carry far less debt.

This very simple tactic--changing the default position so that customers are automatically enrolled in bill-payment plans instead of having to take affirmative steps to opt into such services--can be applied to deal with other credit card hassles. The most egregious industry abuse is the practice of "universal default," in which a company retroactively raises interest rates, even for customers who never missed a payment with the company itself. Few credit card companies engaged in this practice until recently, and even today less than half do so; there is no reason to believe such a tactic is necessary for business. Congress should require companies to drop this tactic unless a consumer specifically authorizes them do so in exchange for lower fees or better benefits.

Changing the default rule would also help with one additional problem: over-the-limit charges. In the past, if you handed a waiter a maxed-out credit card, he'd come back and tell you your card was declined, and you'd have to pay in cash, with another credit card, or by doing the dishes. Now, as a "service," companies accept the charges on a card that has reached its credit limit, and then they impose a large fee. Companies should be required to get approval for the practice--either by letting consumers sign up in advance (which few likely would) or by giving customers a choice at the point of sale. The latter is essentially what now happens when you use your ATM card at a bank that is not your own--you are warned before going ahead with a transaction that it will impose a $1 or $2 charge. Without customer approval, the over-the-limit transaction would simply be declined. This requirement wouldn't prevent customers from exceeding their limit when they actively chose to do so. But it would make sure that they do not unknowingly incur these charges.

Finally, consumers need to know the risks associated with their credit cards. Companies have information about their cardholders' borrowing habits--how much debt they have taken on in the past, how often their payments have been late, and what costs can be expected if they continue borrowing at similar levels. Credit-card companies use this information to make all sorts of decisions about consumers, including whom to target with which offers. It is only fair that customers get the same information. Credit-card companies can and should give customers informed predictions about their future borrowing: for instance, "If you borrow in the next two years like you borrowed in the last two years, you will pay $1,200 in fees and interest." And they should be required to include this information on bills.

In addition, a rating system could help consumers judge the risks involved with different cards. Years ago, federal regulators created crash-test ratings to inform car-buyers of the safety risks associated with various models. A similar system for credit cards could use a simple "Red-Yellow-Green" formulation to rate cards based on the potential costs to borrowers--fees, penalty interest rates, and the frequency with which they are imposed. In addition to helping consumers protect themselves, such a system would help create a market for more "green cards." These might offer fewer bells and whistles--not as many frequent-flier miles, perhaps an annual fee--but they would also have lower penalty fees and interest rates. Consultants like Kahr say that there isn't a market for such cards. But the auto industry once offered the same line: "Safety doesn't sell." Actually, it does, as companies like Michelin and Volvo know well. But it only sells if the government helps build the market first.

Crash-tested credit cards

To listen to credit-card companies argue that high levels of consumer debt are not their fault is to hear, ringing in your ears, the complaints of the auto industry 40 years ago. It's a matter of "personal responsibility," the credit companies say. They can't help it if consumers can't help themselves. In the 1960s, car companies also cited personal responsibility, blaming "the nuts behind the wheel" for high accident and fatality rates on the road.

As Americans recognized then, personal and social responsibility aren't mutually exclusive. People make mistakes, but government can help reduce the rate of those mistakes and soften their impact when they do occur. That's what features like better brake lights and seat belts do. Credit cards need to be re-engineered in the same way.

With a few honorable exceptions, politicians of both parties have mostly ignored credit abuses. As the debacle of the bankruptcy bill demonstrated once again, the companies are influential donors. The consumer groups that care most about debt are not powerful players in either party. And the entire personal-debt problem is often overlooked by campaign professionals who focus on the issues they've always known, such as jobs, health care, and Social Security.

But countless Americans already experience the hardship of unfair lending practices, and those who feel it most acutely are the working-class families whose support progressives have been losing. Merlot Democrats may fret about how to arbitrage frequent-flier miles for discounts at L.L. Bean, but cash-strapped parents worry about whether they'll even make a dent in next month's credit-card bills. At a time of widespread economic insecurity, the ranks of those families are only increasing.

Many Democratic policy solutions depend on tax increases or government program expansions, but the battle against abusive credit-card practices demands neither. It simply requires that progressives honor one of their simplest, noblest commandments: Stand up for regular people. Not by providing for them, but by giving them the tools to protect themselves. The abuses of the credit-card industry cry out for a new consumer-protection movement. Progressives ought to lead it.

Robert Gordon is senior vice president of the Center for American Progress, where Derek Douglas is associate director for economic policy.


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