Is Debt in the CARDs for You?

Last month, the CARD (Credit Card Accountability, Responsibility and Disclosure) Act went into effect, after having been signed into law on May 22 last year. One of the fastest-growing problems for Americans is the ever-increasing size of their debt. This comes from many sources — e.g., school loans, mortgages, and credit cards — and this legislation was written in an attempt to curb one significant source.

Credit card contracts have become increasingly complicated and ridden with hidden fees in recent years, as financial institutions have up until now had the freedom to impose such fees and rate hikes without notice or advance consent by the consumer. According to a White House press release issued in May 2009, “Every year, Americans pay around $15 billion in penalty fees.” Legislators hoped their bill would foster transparency, accountability, and responsibility on the part of banks, credit unions, and other financial institutions.

These are some of the CARD Act’s provisions, as summarized by the White House press release:

• Bans Retroactive Rate Increases: Bans rate increases on existing balances due to “any time, any reason” or “universal default” and severely restricts retroactive rate increases due to late payment.
• First Year Protection: Contract terms must be clearly spelled out and stable for the entirety of the first year. Firms may continue to offer promotional rates with new accounts or during the life of an account, but these rates must be clearly disclosed and last at least 6 months.
• Ends Late Fee Traps: Institutions will have to give card holders a reasonable time to pay the monthly bill – at least 21 calendar days from time of mailing. The act also ends late fee traps such as weekend deadlines, due dates that change each month, and deadlines that fall in the middle of the day.
• Enforces Fair Interest Calculation: Credit card companies will be required to apply excess payments to the highest interest balance first, as consumers expect them to do. The act also ends the confusing and unfair practice by which issuers use the balance in a previous month to calculate interest charges on the current month, so called “double-cycle” billing.
• Requires Opt-In to Over-Limit Fees: Consumers will find it easier to avoid over-limit fees because institutions will have to obtain a consumer’s permission to process transactions that would place the account over the limit.
• Limits Fees on Gift and Stored Value Cards: The act enhances disclosure on fees for gift and stored value cards and restricts inactivity fees unless the card has been inactive for at least 12 months.
• Plain Sight /Plain Language Disclosures: Credit card contract terms will be disclosed in language that consumers can see and understand so they can avoid unnecessary costs and manage their finances.
• Real Information about the Financial Consequences of Decisions: Issuers will be required to show the consequences to consumers of their credit decisions.

Increasing levels of consumer debt are certainly worrisome, but new legislation setting mandates for credit card companies and financial institutions will almost certainly cause problems, and could even make the status quo situation worse. As mentioned in an article on MSN Money, there is currently no cap on how high interest rates could go. And, as expected, card companies are already devising methods of circumventing the provisions of the new legislation. They are developing new products that aren’t specifically banned but that still impose the type of fees and interest rates that this legislation was intended to combat.

Reason editor Nick Gillespie pointed out in a recent article that this type of legislation stunts the development of financial instruments that could be otherwise used by responsible credit card holders, and so is not the best way to ensure that consumers obtain access to reliable credit. Gillespie points out, “No financial crisis is created by access to credit per se; it’s created by real and presumed government bailouts of bad decisions made by folks with access to credit.” As a result, this new government legislation may help to exacerbate the negative aspects of the economic climate.

There has also been discussion of the creation of a Consumer Financial Protection Agency that would attempt to ensure that consumers of credit cards and other financial instruments are protected from practices that the agency deems to be unfair. However, this idea also deserves scrutiny, because it would impose more costly rules and regulations, stunting growth and innovation. As Anthony Randazzo argued in another Reason article, it would most likely create conflicts between federal and state governments, among other problems.

The Federal Reserve is cracking down on an analogous issue: overdraft fees. As a part-time bank teller, I see this issue arise more often than you might expect. It is a baffling and complex issue for many account holders. In the near future, financial institutions will be required to offer customers the ability to make decisions about overdraft services and fees. What most account holders don’t realize is that they have an overdraft matrix — an amount that they are allowed to overdraw their account — based on complex factors. At the time of a transaction that will pull funds from an account, customers are not presented with the knowledge that they are about to overdraw their available funds. The purchase or ATM withdrawal simply goes through successfully, and later later entails a hefty fee. If customers are not aware that this has happened, and make a few more purchases with that account on the same day, the same sizable fee will recur — for as many times as they charge an individual transaction and overdraw the account. This can quickly add up to a significant sum of money. It is true that account holders have the responsibility to know how much money is available in their accounts and keep track of whether they will overdraw, but the new rules will require that consumers be presented with the choice either to overdraw their account and pay the associated fee — a service provided by their financial institution — or to have the transaction declined. These rules are expected to take effect in July. This ability to choose between voluntarily paying an overdraft fee and abstaining from a particular transaction will be a positive development for many.

The impulse to help consumers during the financial crisis is admirable, but the Credit Card Act and a proposed Consumer Financial Protection Agency will also have hidden costs — downfalls that may not be worth the expected benefits. Some consumers of credit cards, loans, bank accounts, and other financial instruments are suffering from an economic phenomenon called “information asymmetry,” whereby relevant information is known to some but not all parties involved in market transactions. While such asymmetry applies to some degree in every market, the gap of knowledge between the producers and consumers of financial instruments has grown significantly. I suggest, however, that instead of formulating costly rules and regulations regarding fees, interest rates, and certain types of financial instruments, more attention be paid to allowing consumers to make these choices for themselves. In order for consumers to make better decisions, however, resources must be applied toward educating consumers about these instruments, and bringing greater transparency to financial institutions’ operations. When consumers feel confident that they fully understand the financial instruments they use, it may also help to stave off the urge that regulators often have to indulge their paternal instincts and attempt to protect us to the point of stifling us.