The Credit Cardholder’s Bill of Rights, which was signed into law on May 22, is the first major overhaul of credit card regulation in 30 years. Is the bill a game-changer for the way consumers use credit or the way lenders dole it out? We spoke with assistant finance professor Enrichetta Ravina, who has done research on the credit card industry and consumer behavior, about the relationship between the lenders and borrowers, how it might change, and whether credit cards make us happier.
Now that credit card holders have a bill of rights, how might that affect consumer behavior?
1. Better debt management More transparency in the credit card terms could mean that consumers are more informed and better understand the terms of their credit card contract. They might avoid paying fees due to their inattention/misinformation and to switch to cheaper forms of credit if they need to borrow. The caveat is that more information doesn’t always lead to restraint. In the same way that knowing that fats are unhealthy doesn’t make everybody restrain from fast food, it is unlikely that being better informed on the terms of the credit card contract will make everybody manage their debt more carefully.
2. Prevent early onset debt New restrictions for issuing cards to people below 21 will make it harder for students and very young consumers to have easy access to credit. The legislation is aimed at protecting a category that might be less financially educated, has fewer incentives to be financially responsible and preventing that they become overwhelmed by debt even before starting their working life.
3. Harder to get easy credit The new legislation requires credit card companies to wait until the account is 60 days late before applying a penalty interest rate and to give 45-day advance notice before changing the interest rates or any other terms. Thus, the credit card companies’ pricing strategy will change. A better ex-ante assessment of the creditworthiness of the consumers will be necessary and credit card contracts will have lower credit limits, higher interest rates for certain categories of consumers and more upfront fees. Lower credit limits and higher interest rates will make it harder for overly optimistic, financially uneducated consumers to get into unmanageably high levels of debt.
What does a consumer’s spending say about his or her behavior?
Most consumers are very predictable in their credit card use. In my research I find that consumers exhibit a high degree of habit in their consumption choice and that they prefer a smooth, increasing consumption path. Demographics like gender, age and income bracket are important, but mostly people’s spending on catalog and online shopping and on other credit cards are the best predictors of their behavior and of whether he or she will carry a balance, pay late or always be on time.
Who are credit card companies making money from?
The most profitable consumers for a credit card company, and therefore the most sought after, are those that spend a lot, pay late and carry a balance (which 45% of Americans do). People’s attitudes to money and their finances tends to be remarkably consistent across financial instruments and therefore people that miss payments on other credit cards and auto loans, stretch themselves with high loan-to-value mortgages are more likely to do the same on this card. Among these very profitable consumers, however, are those that “hide” and who will generate charges only for a short period and will soon default.
Can credit card companies tell who might default from their spending behavior?
It is very difficult to predict this behavior early in advance. These consumers that are very risky are those with limited financial education. Such consumers do not understand the terms of the credit card contracts, are not good at budgeting, saving and spending within their means. At the beginning, they are very profitable for the credit card companies because they generate fees and interest charges. However, once an income shock hits them, or their spending habits get out of control, they rapidly become the worst type of accounts.
What is the upside to easy credit?
Credit cards constitute a tremendous opportunity for some consumers and are very important for economic growth. They allow entrepreneurs to finance the very first stages of their companies when it is hard or impossible to get a loan from a bank. They also allow households to finance durables, consumption goods and other projects. For these reasons, they promote economic activity and a more efficient allocation of economic resources. Compared to other countries where credit cards (and debt) are less diffused, U.S. consumers face more dangers, but also more opportunities and more means to fulfill their projects.
Does this greater opportunity and means to fulfill projects translate into more happiness?
In my research I find that happiness is a relative concept. Above a certain level of consumption that satisfies the necessities of a comfortable life, happiness doesn’t depend on the amount we consume, but rather on the amount we consume compared to the people around us. The reference group we belong to are work colleagues, neighbors, people with a similar socioeconomic status to which we tend to compare ourselves. Credit cards can be used to consume more than the reference group (even though the income is not enough to cover spending), in the hope that income will continue to grow or that no emergency comes to disrupt this fragile equilibrium. Such a use of the credit card is usually associated with short-term happiness and economic problems and anxiety down the road.
Photo credit: Andres Rueda Lopez