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Blindfolded Into Debt: A Comparison of Credit Card Costs and Conditions at Banks and Credit Unions
This entry was posted on 9/16/2006 5:00 PM and is filed under Credit Card.
By Tim Westrich and Malcolm Bush, July, 2005,
Woodstock Institute, 407 S. Dearborn, Suite 550, Chicago, IL 60605, (312) 427-8070,
email: woodstock@woodstockinst.org, webpage: www.woodstockinst.org, (c)2005 by Woodstock Institute
http://woodstockinst.org/document/blindfoldedintodebt_7-5-05_westrich_bush.pdf
Introduction
The avalanche of credit card solicitations to U.S. households has concided in a huge increase of credit card debt. The degree to which this increase in debt is a problem or a sign of a vibrant economy is hotly debated. But clearly credit card debt is a driver of overall debt and is partly a result of the highly expensive and opaque terms and conditions applied to credit card borrowing. Some issuers ’1 policies – such as increasing rates and credit limits to those already deep in debt – make it likely that those borrowers will find it hard to escape an accelerating spiral of debt. Even those households with high credit card balances that eventually get out of debt will pay a high price. In today’s industry, a handful of the most sophisticated credit card issuers now perform complex analyses on vast data sets that reveal the detailed patterns of their customers’ financial behavior; the issuers then fine-tune their products to maximize income based on these models. While consumers are ultimately responsible for what they buy, the way in which financial institutions construct and describe credit card terms makes it increasingly difficult for consumers to understand the products they use.
The debate about the overall indebtedness of families in the U.S. is partly a result of the legitimately different ways in which debt can be measured. A figure of gross indebtedness is not very useful in itself partly because some debt, for example a reasonable amount of home mortgage debt or debt resulting from college tuition, should also be seen as an investment in the future. Moreover, the seriousness of debt is partly a function of how large it is measured against assets and income. The measurement of U.S. savings rates has similar complications. The government measure of savings does not, for example, include the appreciation of existing savings ’ assets. This said, there are reasons for serious concern about debt levels.
Personal bankruptcies nearly doubled between 1990 and 2002. 2 A large number of people are borrowing heavily against their homes, so that while the total value of single family homes has risen quite dramatically in recent years, the amount of equity people have in their homes has risen by a much more modest amount. Equity as a percent of the value of homes fell to a post-World War II low in 2004; whereas in 1950 homeowners in aggregate owned 80 percent of the total value of their homes, today homeowners own only 55 percent of the total value.3 Further the ratio of debt to assets is a ratio that can change dramatically if the assets, particularly house values and the stock market, decline significantly.
Credit cards also can be used to pay off other debt that would otherwise have forced repayment or bankruptcy, thus stringing out repayment until the debt bubble gets even larger.
While the magnitude of U.S. households ’ debt has been well-documented, the reasons why U.S. families are so deeply in debt are less clear. The data suggest that rising debt is likely due to a combination of factors, among them: a long-term stagnation in real wages, despite the strong economy of the 1990s;4 a large increase in debt related to the rising costs of medical expenses, especially for people without medical insurance; and a powerful culture of consumption. However, this report examines the credit card industry itself as one of the reasons for high debt. Credit card issuers have set up an intricate trap of penalties and fees, all coded in small print with complex legal language, which makes it very easy for households to get mired in debt.
If the U.S. credit card industry were homogenous it would be more difficult to find a standard against which to measure the fairness of the product. But the industry is bifurcated in a way that allows a comparison of costs, terms, and conditions. Large banks and large credit unions both issue credit cards thus allowing a within credit card industry comparison. This report examines the basic issues surrounding credit card products and includes a comparison of the terms and conditions of credit cards offered by banks and credit cards offered by credit unions. This comparison should start with a brief description of the basic differences in purpose and relevant structures between these two kinds of financial institutions.
Credit unions are not-for-profit cooperatives that distribute any surplus not reinvested in the institution as dividends to members. In addition to their cooperative mission, they also have by tradition and federal intent a mission to serve “people of small means”. As prior Woodstock Institute’s research shows, there is evidence that credit unions do not fulfill that latter mission very successfully.5 But credit unions by definition are not profit maximizers; they encourage savings (indeed the basic credit union account, a share account is a savings account); and they have a tradition of providing formal and informal financial advice to their members. This mission is one reason why credit union issued credit cards might have different terms than cards issued by other financial institutions. Another is that credit unions have different cost structures than banks. Because they are nonprofit cooperatives and because they have a mission of serving lower-income people, they are exempt from most federal and state taxes. However, they cannot raise funds from the open market and have to build equity from retained earnings. Credit unions are also restricted, compared to banks, in the products they can offer and the lines of business they can enter.
Banks, on the other hand, are driven by the need for a certain level of returns on assets and equity. They may also justify high interest rates and fees as the appropriate cost of extending credit to high-risk customers. On that point, the evidence suggests that whatever their risks, their profits are very high. In 2004, the average return on assets 6 at credit card issuers was 4.5 percent – the highest level since 1988.7 Credit card lending is one of the most profitable sectors in the financial services industry, and many credit card banks have profits higher than such profitable companies as Microsoft and Wal-Mart.8 Banks also have a different regulatory structure than credit unions although both types of institutions are subject to stringent safety and soundness reviews. They are also both subject to the provisions of the Patriot Act which imposes very heavy paper work burdens. Credit unions, unlike banks, are not subject to the Community Reinvestment Act.
This report is organized in the following way. First, it briefly reviews the growth of the credit card industry, and the rise of personal debt in the United States. Second, it will report data from a survey of credit cards offered by three groups of financial institutions: the ten largest U.S.-based bank and thrift companies, ranked by the total amount of credit card loans; the ten largest U.S.-based credit unions, ranked by the total amount of credit card loans; and the largest federally-chartered credit unions in the Chicago metropolitan area. Third, the paper will compare the basic features of these three groups of credit cards, including the purchase rate, introductory rate, default rate, fees, terms and conditions, cash advances, and balance transfers. The report concludes with recommendations for improving credit card products to make them fairer for the average consumer.
This report and its recommendations are especially timely because the Federal Reserve Board is currently considering financial sector and consumer responses to a proposal to amend the regulations that govern credit cards under the federal Truth in Lending statute.
1In credit card lexicon, “issuer” is the term for the depository institution (bank, thrift, or credit union) that issues and funds the credit card. It sets the rate, terms, and conditions independently from the brand. A few of the issuers, such as Capital One and MBNA, are “special purpose” banks and have no other business outside of credit cards. “Brand” or “network” is the term for the association to which the issuer belongs, i.e., either Visa or MasterCard. The brand owns the infrastructure that makes the transaction, while the issuer pays for the goods purchased. In addition to firms offering cards through the two major networks, two large nonbank firms, American Express Co. and Discover Financial Services (a unit of Morgan Stanley Dean Witter and Co.), issue independent cards to the public.
2 Alex Baker, “Life and Debt: Why American Families are Borrowing to the Hilt.” Century Foundation, 2004.
3 Paul Kasriel, “Begging the Chairman’s Pardon – Household Balance Sheets are Improving?” Northern Trust Corporation: Positive Economic Commentary, 17 July, 2003. Found online at http://www.northerntrust.com/library/econ_research/weekly/us/030717.html.
4 According to income distribution charts assembled by United for a Fair Economy. Found online at http://www.faireconomy.org/research/income_charts.html, last accessed 11 April, 2005.
5Woodstock’s report found that credit unions in the six-county Chicago region serve much lower percentages of lower-income households than they do middle- and upper-income households. Complete results can be found in Katy Jacob, Malcolm Bush, and Dan Immergluck, “Rhetoric and Reality: An Analysis of Mainstream Credit Unions’ Record of Serving Low-Income People.” Chicago: Woodstock Institute, February 2005.
6 Return on assets (or ROA) is a measure of business performance that shows a firm’s profit per dollar of assets; it is derived from dividing net income by average total assets; thus, the higher the ROA, the more profitable the business. Regardless of size, a bank with a ROA of 1 percent or better is typically considered to be performing well.
7 Lavonne Kuykendall, “Card Lenders Earned More Despite Weak Portfolio Growth,” American Banker, 3 January, 2005.
8 See http://www.pbs.org/wgbh/pages/frontline/shows/credit/interviews/yingling.html. Last accessed 15 April, 2005.
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