Default rules to help reduce credit card defaults

Reader Aaron Keating writes in with two interesting and thoughtful ideas on ways that credit card companies could nudge their customers to manage their credit better.

The social and economic problems caused by excessive credit card debt are widely known. Below I’ve outlined two default choices currently used by most credit card companies, and suggest nudges that could help consumers rein in excessive credit card use, minimize future credit problems, and use available credit more wisely.

1. “Suggested” vs. “Minimum” Payments

Credit card statements are required by law to require a minimum payment that includes a small percentage (2%-4%) of the principal carried on the card, as well as the interest accrued to date. Depending on the balance carried, the minimum payment can be as low as $10. But as recent research has noted:

“…although minimum payments are designed to protect consumers from the effect of compounding interest, they actually act as “psychological anchors”. In other words, when people are assigned a minimum amount, they generally pay less than they would have if no amount had been listed. A lower payment results in greater interest payments as the debt accrues. If this is the case, the laws that are supposed to protect consumers are unintentionally providing a greater barrier to avoiding credit card debt.”[1]

To combat this problem — while preserving individual choice about payment amounts — I suggest credit card companies present a different default payment option to consumers when the total balance exceeds a predetermined amount, as follows:

If the total balance is small enough that by making the minimum payment the balance would be paid in full within one year, the credit card company calculates and display the minimum payment due as it does now. However, two other pieces of information are also shown: the number of months remaining before the balance is paid in full at that payment level, and the total cost, including interest, the consumer will pay by the end of that time period.[2]

If the total balance is large enough that the minimum payment is not sufficient to pay the balance within one year, a second payment choice is also presented: the “suggested” payment, which shows monthly payment required to pay the balance in full (with interest) in 1 year. As noted above, the number of months remaining before the balance will be paid in full, and the total cost the consumer will pay over that time period (with interest) are also displayed.

If the total balance is large enough that the minimum payment is not sufficient to pay the balance plus interest within 1 year, the “suggested” payment, months remaining, and total interest information could reflect a 2- or even 3-year repayment plan. But for those consumers with credit card debt levels high enough that their minimum payment won’t pay the balance within three years, a brief sentence suggesting they contact a local, non-profit credit counseling agency – along with the agency’s name and phone number – should be included with the credit card statement.

Presenting a “suggested” payment alongside the minimum amount due, with information about the outcomes of each choice, will provide two defaults from which consumers can choose. By highlighting the consequences of their choice and making outcomes easily comparable, consumers can be gently encouraged to pay off their cards sooner and avoid overextending their debt.

2. Opt-in to Credit Limit Increases

Credit card limit increases are often opt-out by default; consumers receive a letter from their credit card company informing them their credit line has been increased. An opt-in process should be used instead, so consumers can actively choose whether they wish to extend their credit lines.

Information about a proposed credit card limit increase should also include the total number of months required to pay the full balance of the card at the proposed new credit limit, using the minimum, one-year, and three-year payoff levels as outlined in #1 above.

Consumers would still be free to contact their credit card company to request an increase if they need it, and credit card companies would still be free to offer increases – but the information noted above will provide some context for the consumer’s decision, and ensure the choice to extend a credit line is conscious and deliberate.

These two suggestions would serve the consumer’s interest in credit management more effectively than policies currently in use by most credit card companies. The new defaults may cause smaller profit margins for credit card companies in the short-run, but improving economic and community stability for individuals, communities and the nation as a whole will benefit all consumers and businesses – credit card companies included – over the long-term.

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10 Responses to “Default rules to help reduce credit card defaults”

  1. Mikalfc Says:

    a fine point. However, the premise of the post assumes that credit card companies have an interest in helping consumers manage their credit. Credit card companies, as well as all businesses, exist to make a profit. As long as they have a business model where higher rates and increased consumer borrowing leads to greater profits there is no incentive to improve credit scores. Indeed improved credit scores might lead to greater profits for competitors, since consumers would be able to shop for credit more freely.

  2. Rahul Basu Says:

    Nice, but credit card companies make their money from interest and fees. This is different from the early days of credit cards where most of the money was made from interchange fees, essentially the discount that the merchant provided.

    Incidentally, Amex still makes a lot of its money from interchange, but that leads it to more credit worthy customers.

  3. C.Most Says:

    Those are very good suggestions and would be very helpful for the consumer.

    Number one in my book of grievances with credit card companies is their unmitigated greed in the ever higher interest rates being charged ~ there ought to be a law against 24.99+% interest rates charged! Any ideas ?

  4. John Gibbard Says:

    Two things in response to the previous comments (Mikalfc, Rahul Basu and C.Most), neither of which should be taken as ranting…

    Ok, so card companies make money from fees and interest. One assumes that the profit margins on these are healthy allowing for them to take a small cut here and then use volume to make up the difference? By demonstrating a considered (even *ethical*) stance by adopting such practices endows the company with highly marketable brand values and, you would hope, would increase their market share. It’s this kind of value proposition that is required to differentiate financial services products.

    Secondly (C.Most) is enacting a law against high interest rates in the spirit of libertarian paternalism? Sure, high rates are not nice, but nudges are just that – gentle encouragement to choose something better – not legally-enforced ‘choice’.

  5. Kaiwai Says:

    Many people get into the trouble where the pay a certain amount off then go and spend the amount they put onto the card – so they never really actually get to pay off their debt; they tredd water so that when a big financial crisis comes along they are wiped out. There really no alternatives apart from getting a personal loan.

    How about this option: Allow customers to ‘freeze’ their credit card so that they cannot use it (or transfer money off it) until the pay it off in full. It would stop the cycle which some people get themselves into.

  6. fassd.com Says:

    Most high interest credit cards are usually easy to get and really the interest rate only matters if you roll over your balances from month to month. People that have had bankruptcies, judgments or just have a bad credit rating, for what ever reason are the most common applicants for high interest credit cards.

  7. Mike Says:

    Thanks for the tips. I always play by the rules however my Wife is a bit of a renegade! In seriousness is it possibleto call the credit card company and lower credit limits? I understand the credit score hit but i think it puts some controls on things.

  8. Thomas Goldman Says:

    While I agree that some degree of clearer and better regulations in the credit card industry will help to some extent, in my opinion it’s the fact that most people get little or no real financial education from either their parents or the education system, and what beliefs are transmitted about such things tend to be false or extremely out of date.

    thanks for the info.

    TG

  9. Mike Lukjaniec Says:

    Some credit companies opt in as soon as they see a decent activity. It should be avoided at any cost specially if you are struggling the original amout.

    Regards

  10. smithrobert Says:

    By smithrobert,

    we understood that due to social and economic problems the credit card users could not face any problems so, some nudges are suggested for the consumers so that thy should not be able to face any problem for ever in future……

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