There’s been a lot of talk lately about using regulatory bodies to cap credit card interest rates as a way to lower costs for Americans in today’s softening economy.
On the surface, this sounds logical.
If you cap credit card interest rates to some arbitrary lower number—like the 10% cap currently being proposed—consumers’ monthly payments should go down, right? Well, maybe, but only very briefly. And by that, I mean maybe a few months at best. But what happens after that?
In order to truly understand the inevitable outcome, you have to first understand the business model for the credit card industry. Unfortunately, most people lack basic financial literacy, so they don’t understand this and many other financial topics. That’s why the finances of so many Americans are in shambles today. It’s also why absurd ideas like capping credit card rates make it so easy for politicians to win votes by proposing them.
So let’s start by unpacking the business model for the credit card industry.
A credit card company makes money by giving you access to capital, and charging you interest while that debt remains outstanding.
The rate they charge is based largely on your credit score, which is a number generated by an incredibly comprehensive algorithm that analyzes a tremendous amount of data to determine the likelihood of you repaying your debt on time.
Some of the factors include your:
- Payment history
- Income
- Amount of outstanding debt
- Work history
The higher your credit score, the lower your rate will typically be. The inverse is also true, so the lower your score, the higher your rate will be. And this is across the board, so even if you’ve always paid a particular credit card on time but your credit score drops, that lender will likely increase your rate.
That’s because your credit score is a proxy for risk to the lender.
The higher the score, the more likely a borrower is to repay their debt, so lenders don’t need to worry as much about them defaulting. But the lower the score, the more likely a borrower is to default so the lender loses both the interest they had planned for—which is their profit—as well as the initial capital they provided to the borrower. Now they’re at a significant loss that has to be recouped.
To mitigate the risk of losses, credit card companies carefully analyze the risk of default based on a borrower’s credit score, and those who pose a greater risk are charged a higher rate to compensate. Essentially, that risk is baked into the “price” to access capital and spread out across all borrowers within a particular range of credit scores.
This is necessary because a single default can wipe out all of the profit generated from dozens of accounts that pay on time. If credit card companies didn’t operate this way, losses would quickly outpace profit, credit card companies would go out of business, and consumers would lose access to credit. This is economic reality.
The math simply doesn’t work
When you look at the actual data, you realize that a 10% rate cap isn’t just difficult for banks—it’s mathematically impossible.
Let’s break down the real costs of running a credit card program, using hard data from the Federal Reserve Bank of New York.
First, banks have to acquire the money they lend you. The benchmark for this is the Federal Reserve’s Prime Rate, which currently sits at 6.75%. Second, it costs money to actually run the credit card program—keeping the lights on, paying salaries, maintaining customer service, and preventing fraud. According to the New York Fed, these operating expenses average 4% to 5% of balances annually. Finally, you have to account for the people who don’t pay their bills. This is known as the charge-off rate. According to the NY Fed, the annual charge-off rate for a subprime borrower (someone with a 600 FICO score) is a staggering 9.3%.
Add those up:
- Cost of Funds: 6.75%
- Operating Expenses: 4.00% (using the conservative end)
- Subprime Charge-Offs: 9.30%
- Total Cost to Lend: 20.05%
If the government forces banks to cap interest rates at 10%, a lender would take a guaranteed 10% loss on every dollar lent to a subprime borrower. You physically can’t do that because the math doesn’t work.
Even lending to a prime borrower with a 720 FICO score—who has a lower 5.7% charge-off rate—costs the bank over 16%. Under a 10% cap, lending to a prime borrower is still a guaranteed loss.
The unintended consequences
So what would happen if regulators placed a lower cap on interest rates?
Credit card companies would be forced to change how they offer credit, or more precisely, who they offer it to. Due to the risk, they would immediately drop clients with lower credit scores because they’re the most likely to default.
This means only borrowers with the absolute highest credit scores would be able to get credit. So instead of saving Americans money, this would actually just remove access for most people.
We already know exactly how this plays out. When Illinois and South Dakota implemented 36% interest rate caps, a New York Fed study found that subprime borrowers in those states saw their debt balances decline by nearly 17%, and the number of open accounts dropped by 20%. If a 36% cap causes that much damage, a 10% cap would obliterate the market. The American Bankers Association estimates that under a 10% cap, up to 85% of open credit card accounts nationwide would be closed or drastically reduced.
That’s dangerous, both for individuals because it would take away a financial lifeline, and for the economy as a whole because it would cause a steep decline in spending.
The problem is even bigger than it may first seem because the small business community depends on credit to make critical investments and maintain payroll to survive lean times. Because business credit cards universally require a personal guarantee, the underwriting is tied to the business owner’s personal credit profile. If consumer credit is restricted, small business credit is simultaneously choked off. Without access to this credit, many will be forced to make layoffs, which means an increase in unemployment.
It creates a dangerous downward spiral. And as a side effect, banks would immediately eliminate all cash-back and travel rewards programs just to survive the losses.
As usual, politicians are proposing a shortsighted proposal they know will hurt Americans, to solve a problem the government actually caused, and because most people aren’t financially literate, they’re cheering it on.
Our economy today is shaky. There’s no debate on that. But the solution isn’t more government intervention—that’s the cause. The real solution is to let the free market work.
Putting an artificial cap on interest rates will only hurt the people it’s being proposed to supposedly protect.