When business investors need money, they have places they can go to borrow money at decent interest rates. Those interest rates are usually carefully regulated and scrutinized and discussed publicly to make sure they have appropriate settings. The rates even have names. If those rates ever even hint of entering the double digits, that is, if they hit 10% or higher, a near panic ensues, news stories abound, and government flies into urgent action.
Why? Because business knows that rates even that high are seriously injurious to cash flow. It's hard to reliably make money at double-digit rates and so sustaining the need to pay out at those rates is a problem. There might, of course, be specific reasons to enter into such risk on a short-term basis, but suggesting that the average consumer has the savvy to understand and navigate the implications of sustained compound interest at 15% or 20% is very questionable.
It's sometimes said that the price of certain borrowing has to be that high because the market demands it. Some borrowers are poor risks and the market reflects that by charging them more—or so the story goes. But the market also influences whether these are poor risks by creating the circumstances that dictate how difficult it is to pay back loans.
It's something of a self-fulfilling prophecy. If people were accorded 1% interest rates, they might find it a lot easier to repay money all the time. If businesses were charged rates of 25% or 75% or 100%, they might find it pretty hard to pay back any loan ever. I'm not suggesting businesses pay high rates, I'm just trying to highlight the consequence of suggesting that consumers are bad for having bad habits in repaying loans. Another possible explanation is that when you're offered higher rates, it's harder to repay.
The finances of people are different than those of businesses—but not in a good way. Businesses often have more expertise, capital, or other financial advantages than regular people. And businesses get tax deductions for the interest they pay.
Once one borrows money, one has still live a normal life and pay all the same things, but one also has to earn extra money enough to pay back the money owed. So one needs to be making extra money at a rate sufficient to do that. If businesses, with all their advantages, have trouble paying back at low interest rates, why will the poorest in our society that need to resort to credit cards just to make ends meet somehow fare better when it comes time to pay back their debt. We need to either lend people money at humane rates, or not lend money. But to pretend that people of no means are going to suddenly repay at astronomical rates is crazy; and it speaks more about the lack of judgment of the lender, who is trained in finance, than the borrower, who may not be.
So my point is simple: If 10% is a problem rate for business, you can be pretty sure it's not a sign of smooth sailing ahead for ordinary people. But the Government does not name or track the rates available to people. It doesn't even segment it and track it as several rates.
The really exciting part would be the rich public dialog trying to name what it is that should cause us to give one person better rates than the other. I bet if you had to name the reason, it would provoke a lot of really interesting discussion about what was going on with the rates. So, just to pick some unlikely names for the point of discussion, we might have the “Preferred Borrower's Rate,” the “Average Borrower's Rate,” and the “Deadbeat Rate.”
Or you might decide we should make it like sentences for crimes, where people from affluent families or people with “white collar” jobs got different treatment than people from poor familes or people with “blue collar” jobs. Or maybe you think that rich vs. poor is not the line it is, or should be, drawn along. We could have the “Honest Borrower's Rate” and the “Shady Borrower's Rate.” Maybe the “Help Me Buy Food Until Payday Rate” or the “I'd Like to Overspend for Christmas and Pay All Next Year Rate” or the “I Need Surgery Rate.” Feel free to suggest your own set of categories.
But whatever names we choose, just imagine how different the public dialog would be if we talked about the rate by name in the same way as we talk about rates like the Discount Rate and the Prime Rate, and if we had government officials who got to decide whether the rate for that needed to be adjusted up or down.
For example, imagine how much more transparency we'd get in Government if we heard a federal official give a press conference saying “As Secretary of Health, I notice the hospitals are getting overcrowded. I therefore suggest we raise the ‘I Need Surgery Rate’ a point or two until demand levels out.” Harsh? Certainly. But honest. After all, are we doing any different when we don't admit that's why some people are using their credit cards and paying whatever rates the credit card people demand just for a shot at that surgery? Credit cards are used for all manner of things by people with nowhere else to turn. By blurring it all together and allowing the rates to float free, it's easy to pretend it doesn't matter.
Credit card rates are to the lending industry what the population of homeless people is to society at large—nameless, faceless entities that may be safely assumed to be all of the same kind, all of no importance, all not worth discussing. It's time to give consumer credit rates a face and a name and to discuss how they come to be.
If you got value from this post, please "rate" it.
This is one in a series of posts on credit cards.
See also:
Hair-Trigger Credit Card “Default Rates” (6 Oct 2008)
Round Up the Usury Suspects (3 Dec 2008)
An All-Volunteer Army of Credit Card Users (5 Dec 2008)
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Comments
Consumers don't do generally do that. They borrow (in the examples you're talking about) because their bank accounts are empty, and they need a bridge loan to eat until their next payday. But often, they lack a real plan for how they're going to pay back the loan, and continue to eat in the next pay period.
Try being a business who has no cash in the bank, is only making minor profits, and is looking for a loan to make this week's payday, and hopes to figure out a way to pay back the loan in the next pay period. No way that business is borrowing money at "prime" rates.
The reason businesses get such better borrowing rates, is because they are much better credit risks.
Kent wrote: "the consequence of suggesting that consumers are bad for having bad habits in repaying loans. Another possible explanation is that when you're offered higher rates, it's harder to repay."
If you were right about this intuition, then it suggests a (banking) startup opportunity. Raise some capital, and start making loans to ordinary people at (the much lower) business rates. According to you, when given a low rate, people will be much better at paying them back.
I strongly suspect you'll find that the startup will fail, and it will discover that low interest rates don't significantly affect the consumer default rate.
Kent wrote: "The really exciting part would be the rich public dialog trying to name what it is that should cause us to give one person better rates than the other. [...] or the “I'd Like to Overspend for Christmas and Pay All Next Year Rate” or the “I Need Surgery Rate.”"
But this is all backwards. Interest rates aren't about the purpose to which you plan to put they money. They're about the likelihood of your default, vs. repayment in full. So the categories you suggest are all meaningless for that industry, because they don't indicate the relevant credit risk to the lender.
Kent wrote: "if we had government officials who got to decide whether the rate for that needed to be adjusted up or down."
And I just want to note that almost all of those commercial rates you're talking about are set by the free market, not by a fiat decision of some government official. Government has only some very crude levers there. Your (consumer) example of narrowly targeting hospital credit, isn't the kind of control that government exerts even with businesses.
As a business, one gets all kinds of unsolicited physmail offers for substantial amounts of SBA credit at very reasonable interest rates. I've gotten them just as often at times when my business was not doing well as when it was. Now maybe those loans wouldn't be granted if asked for, I can't say. I'm just telling you the offer is there and for amounts of credit way bigger than would be extended a person. But just glancing at the forms they sure look like they are a lot less hassle to apply for than consumer loans, and I didn't see any questions about business plans. These may not be the large loans you're thinking of, but they're way bigger than typical consumer loans.
I did not say that charging low rates would cause people to pay back better, I said it would enable them to pay back better. You've reversed the sense of it and the consequences are not the same. It can be the case that charging high rates causes some bad effects even if it's not the case that charging low rates incentivizes good behavior; it could be there are other ways to incentivize good behavior than to charge high rates, for example, without practically causing default by charging high rates.
One way might be to simply disallow the making of money by high rate fees at all. You might say "but what about the people who need it?" The answer might be that they would have to get the money another way. Perhaps we'd find that there was then more stress on the medical industry, but perhaps it would be good we knew that instead of not realizing that some number of credit cards are charged up with that. Perhaps we'd find that some of it was people buying boats, and perhaps then they would not be able to buy boats. Depending on the circumstance, the answer might be different. You justify it on the basis of freedom, but this is like the freedom to carry an unlicensed gun. We don't let people use certain stock trading instruments without verifying they're going to handle it competently, and yet people can ruin themselves just as well here without going through any similar vetting process. (The same is true for home renovation, by the way, and I might even argue home purchase is in the same arena. It's a high-stakes gamble that not everyone is prepared for. We could, for example, require that it only be done with "surplus" money, which I think is what they require for the stocks stuff--I forget which--short selling and the like?)
On your point about whether the government sets the various rates, you're only half-right. Imagine a parent that offers their kid the "freedom" to make a choice. They aren't necessarily really letting them get into trouble. They're watching over them and making sure they're safe. The choice isn't an illusion, but it's an illusion that if they got in a mire, they wouldn't be rescued. Right now you're seeing that play out on wall street. And the fed does similar things by adjusting the few interest rates it has access to at other times. So yes, the rescue might be ineffective. But no, the other rates are not unmonitored or uncared about. Credit card rates, by comparison, are barely monitored. Right now a bill to cap credit card rates at 36% is languishing because some people think it's perfectly healthy and a sign of financial freedom that credit card rates be allowed to go higher. Go ahead, make your best case for an actual real world situation where a revolving line of credit for an average consumer should be 36% rather than some other instrument being more appropriate.
lol, nicely slipped in, Kent.
I have to cautiously agree with much of what Don Geddis has said. However I think I had better visit the rest of your series before I comment further.
Airlines do a similar free-wheeling thing with ticket prices, but in that case it's not really a public policy matter. If the ready and non-discriminatory nature of plane tickets was a political concern, it probably couldn't be done that way because it would defy oversight and discussion. (When people talk about putting airlines back under regulation, maybe this is part of what they mean.)
In this case, because debt is a major issue of public policy that needs some oversight, having fewer categories and more ability to talk about them might be good. I hear someone saying that the present system offers consumers more choices, but the choices it offers them are bad ones in many cases and not subject to oversight. I'm not so sure that fewer choices that are subject to oversight wouldn't be better. And I'm definitely sure that having a discussion on the matter is better than claiming this is a matter of no consequence that should be dismissed without some pretty careful consideration.
"3. Customers who know they will be paying lots of interest. The fact that these customers are arriving knowing they will run up bills that require paying interest means they don't have their finances totally in order. As I recall, the credit card companies aren't motivated to make it better for these people either because they're not sure how much of their business they want."
Later, defending your argument, you stated (speaking again of the Category 3 people) the following:
"Just because they aren't a good risk for credit card companies (who are commercial entities aloud [sic] to exercise personal preference in shunning markets they don't want) doesn't imply society can pick groups of people who are a hassle to help and shun them."
Kent, I disagree with your point, and here is why. I would love to own a Lear jet so I could quit taking commercial flights. The stark reality is that my income level won't support the cost of the jet. The corporate jet dealer has every right to shun my credit application because she/he would recognize my inability to pay the debt in a timely manner. However, it is also their right to choose to offer a finance package tailored to my ability to pay. The jet dealer could offer to finance the purchase at 36% or 100% per annum, and I could either accept or reject their offer. If I choose to accept their offer, I would have to realize that the jet (and possibly other assets I own) would serve as collateral, and I would forfeit the jet as well as all payments I had made toward the purchase of the jet if I was late or missed a montly payment.
I think I understand your line of thinking, and I applaud you for looking out for the "little guy", but when it comes to interest payments, we shouldn't blame the credit card company for trying to make a profit, we should blame the "little guy" for taking on too much financial risk. In my opinion, this isn't about transparency, this is about consumers and their (our ?) poor financial decisons.
I call our present system of shylocking The Pawn Shop Theory of banking, a theory first propounded by an old friend who owned a pawn shop. He justified his usury by saying that if he didn't loan his customers money, they'd be out stealing. It never occurred to him that he was stealing from them, or thatby exacerbating their problems, he was actually increasing the chances that his customers would have to steal later.
In a way, it's the same with bankers who view default as kind of theft, without acknowledging their own responsibility in the default, all the present economic catastrophe is shedding a little light in the dark corner of shylocking.
Yes, risk is to be rewarded, but usury is not. Credit card companies have become little better than the mafia. Charging 22-25% or more on debt while paying 2-3% interest on deposits is usury, and we use to acknowledge that before we let bankers and their paid agents like Phil Gramm write banking laws.
BOTH % rates are ZERO.
Why??
Because I pay off the full balance EVERY STATEMENT.
The bastards probably hate me &, I'm GLAAAAD.
I have to admit that I don't quite understand this. They have the ability to pay back better ... but choose not to? I don't see how high rates can cause bad effects, without the lack of high rates not causing those same bad effects.
In any case, lenders don't really need to understand exactly why people act as they do. All they need to do is correctly predict how they will in fact act. Do high rates (for bad risks) in fact cause more defaults? Would lower rates result in enough less defaults to make up for the lesser income from those who do pay?
It seems to be a simple question of fact. Lenders are just trying to maximize profit. Either lower rates would result in higher profits (in which case, there's a startup opportunity), or it wouldn't (in which case, the current rates are set correctly).
Kent wrote: "You justify it on the basis of freedom, but this is like the freedom to carry an unlicensed gun."
This gets into a deeper question, about so-called victimless crimes, and paternalistic government.
Let me just say, that for me, it makes a huge difference whether the danger is "only" to the decision-maker, or whether innocents can get caught up in the troubles too. (And I'm not talking about indirectly, like a father with a family to feed who screws himself up, so the family suffers too.)
Guns wind up hurting people who are not at all involved, who are complete strangers to the one making the decision. Personally, I demand a much higher standard of compelling societal need, before I'm happy with government telling me what to do in my own life. Hence the "paternalistic government": it's kind of about individual responsibility, vs. wanting the nanny state to protect you from yourself.
(I'm aware that you and I disagree on the optimal placement of that particular line in society.)
"We don't let people use certain stock trading instruments without verifying they're going to handle it competently"
You know, I disagree with that restriction too :-).
"it's an illusion that if they got in a mire, they wouldn't be rescued. Right now you're seeing that play out on wall street."
This is called "moral hazard", and I agree it's a huge, huge problem. Only the giant extent of our financial troubles makes it at all reasonable to even consider bailing out these firms.
But I don't think that's a good thing. I think it's a problem that large firms are coming to expect to be bailed out. Failing companies ought to go bankrupt (in general).
Just to understand this further, you say this because you believe the difference in interest rates implies a huge profit on the part of the lenders, right? And they ought to be happy with a profit half that big?
Again, this sounds like a startup opportunity. Raise some money, go after the same customers, but only charge them 12% instead of 25%. Ought to be a huge success!
Only ... you're aware, aren't you, that not every consumer being charged 25% actually pays back what they owe, right? So as you say, there's some risk involved. Do you happen to know how much risk there is with those customers? How do you know that 25% is not a break-even rate of lending?
In a comment to a previous post in this series, I included a quote from a link Kent provided, which once again seems relevant: "When money is lent on a contract to receive not only the principal sum again, but also an increase by way of compensation for the use, the increase is called interest by those who think it lawful, and usury by those who do not." (Blackstone's Commentaries on the Laws of England, p. 1336).
As you say, bankers hope to compensate by sticking those who do repay with those 22% interest rates. But when their misguided or perhaps malicious business model proves faulty, bankers stand with their hand out looking for the very govt they have long denigrated to bail them out. What that means as a practical matter is that some of the same people who were paying that usurious 22% will now be paying again.
Meanwhile, the fat asses who dreamed up this Ponzi scheme will collect their bonuses out of the bailout funds. Long live the Free-Market Folly.
You quote Blackstone, but a 13th Century mentality is what got us into this mess. Let me return the favor pf a quote:
"The mindset that created a problem can never solve it." Albert Einstein
In case it's escaped your notice, credit card companies can retroactively change the interest rates money borrowed on any card in pretty much an unfettered way. To refer to it as "choice" is inappropriate since it implies there's a better deal in town available to ordinary citizens just trying to get by. I've touched on this a little and have another piece coming on this specific issue.
It's the entire terms of the system we're talking about, not one individual. The 25% is a symptom of creating a revolving account for someone who should never have had one. You're effectively throwing everyone who uses this form of credit into the same pool as anyone else. So, for example, just hypothetically, I take out a card at 8% and someone else takes out a similar card. Now the bank gets nervous that one of us will default. Instead of doing its homework to find out who's at risk, it can just raise both our rates so that the interest it makes covers their risk. Now whatever I had at 8% might be at 12% or 20% or 50% according to present law. It doesn't have to do it all at once. All it has to do is raise the default rate and then redefine default to mean "late on a payment" or something like that and then wait for someone to be short cash on some day, then voila, a cash line at 8% is transformed into a cash line at, say, 25%.... Cards are constantly posturing in precisely just this way right now. The thing you call "choice" may be that you are in some situation where you haven't had to try to change cards, but whether you can or cannot change cards to a better deal is also personally decided and is often not as easy as you think. Most or all credit cards offer pretty much the same terms. So a lot of people in the US are one layoff away from a bad situation if they're using their cards to cover anything significant... and I don't mean frivolities. I mean things like unexpected spikes in expenses including acts of weather, car repairs, surgeries, child's education or other children's emergencies (kids take a while to really be on their own in the world), home heating at a time when oil spikes, property taxes when out of work and the tax doesn't go down just because you have no income, relocation cost if you can't afford your place you couldn't pay the taxes on, and on and on.
Imagine someone getting deeply in debt and facing the prospect of paying off a series of steep bills for the rest of their life, very gradually going deeper and deeper into debt; this constrains everything they do in their future. I think this sometimes happens, and it's actually something that some credit card companies seem to want to happen, to some extent--you see it in their efforts to give credit cards to college students with no income, and in the average debt among college students, which has risen steadily over the years.
Let's contrast this with a business with the same outlook. What can the owners do? They can simply dissolve the business and walk away. That's the way things are intended to work, I think, but I also think that for various reasons it's a lot easier for businesses to declare bankruptcy than it is for individuals, both legally and emotionally, and businesses have steadily been making it more and more difficult for individuals to do this. I find this a bad thing--not necessarily bankruptcy laws and such per se, but the shifting balance of power away from ordinary people.
I think those people ought to declare personal bankruptcy, exactly parallel to the suggestion you have for a business in that situation.
I understand that you considered this, and you think that it's much "easier" for a business to do so than for an individual. But I disagree that the two events are really so different.
I'm trying to understand. You think it's a better world to simply prohibit such people from getting such credit at all, rather than allowing them to borrow such expensive credit? This is very much at odds with my desire for individual responsibility and to treat citizens like adults. But let's go with it for a moment. Because you also say:
"unexpected spikes in expenses including acts of weather, car repairs, surgeries, child's education or other children's emergencies [...], home heating at a time when oil spikes, property taxes when out of work and the tax doesn't go down just because you have no income, relocation cost if you can't afford your place you couldn't pay the taxes on, and on and on."
I'm trying to understand what happens to these very people, in your preferred future world, when they are simply prohibited from borrowing expensive credit card money.
Yes, some advertising (and the associated products) tries to convince you to want something that is probably, in the long run, bad for you.
Do you propose to just ban all such speech? Is this any different from McDonald's advertising Big Macs? See's Candies? Smoking and alcohol, obviously.
There does come a question about when you think people ought to take responsibility for their own decisions. There's always a tradeoff between freedom and a nanny state. I think it's pretty clear where my preferences are, but yours (and Kent's) may well be different.
"But when their misguided [...] business model proves faulty, bankers stand with their hand out looking for the very govt they have long denigrated to bail them out."
I share your objection to this event. But to me, it is not related to the interest rates they were charging. The bailout is the problem, not the interest rates. (And yes, I agree that if the taxpayers promise to bailout a company in need, then they also ought to have a right to regulate its actions prior to the need, in order to limit their risk. But I would hate for every company to be forced to make such a deal.)
"this Ponzi scheme"
And again, I agree with you completely in objecting to Ponzi schemes (and in outlawing them).
But high credit card rates are not Ponzi schemes.
As to your yacht example, there are lots of negative consequences to bankruptcy. So it's not a trivial decision. It will affect your future financial life (borrowing, buying a house with a mortgage, etc.) for a decade or more to come. So, hardly something you would do on a whim.
But it at least (in theory) caps the downside. You shouldn't need to be an indentured servant for the rest of your life.
As to not motivated to work, your model presumes that people are motivated by whether they get something. Those motivated by honor, of course, will be motivated merely to clear their honor, even if nothing is personally in it for them beyond that. So the system as you're describing it, unless it goes to trouble to actively encourage bankruptcy and associate it with honor, works actively against those who seek to discharge their debt with honor and in favor of those who work only because they are paid and who don't mind dismissing debt they took on (to use your phrasing, which for various reasons I don't like) "out of choice". (I don't think the poor have the "choices" you sometimes seem to portray them as having, and I often feel the notion of choice is used more as a way of the well-to-do washing their hands of blame for a system that is actively biased against the working class.)
You wrote: we shouldn't blame the credit card company for trying to make a profit, we should blame the "little guy" for taking on too much financial risk.
I might almost buy this if credit card companies could not change your interest rate dynamically, and especially if credit cards had protection that forbade the company from ever retroactively changing the rate on money already loaned. But since it doesn't work that way, then the only sense in which he took on too much financial risk is by getting the card at all, because cards are huge financial risk if you actualy use them and cannot afford to pay back right away. You don't know you'll be able to make all your payments in the future—if you did you would have the money and not be borrowing it. And so if you can miss one or more payments and have default rates kick in, you're allowing the cards to kick you when you're down. That is not the little guy “ taking on too much financial risk” except insofar as he may have little other option for credit in an unregulated market. As for the company just “trying to make a profit” I think the situation is a lot less innocent than that.
http://www.msnbc.msn.com/id/28294720
Step 0. People get their interest rates raised retroactively. Congress has not yet admitted this is inappropriate.
Step 1. Congress agrees retroactive raising of interest rates bad, passes law to go into effect in July 2010.
Step 2. People get their interest rates raised because step 1 not in effect yet. Congress admits this is bad but doesn't help them.
Step 3. Law goes into effect keeping more people like in Step 2 from being produced.
Step 4. Some people continue to pay at artificially high rates created in step 0 or step 2 because those rates are not rescinded in step 1. Probably rescinding them is hard. But making there be no step 2 does not seem hard. Even if Step 0 victims continued to exist, the least they could do is avoid making more of them.
That will be a very avoidable shame. Anything is better than nothing as a start. This is very important stuff. But it's not enough because of when it starts.