Sunday, September 25, 2016

Why credit card interest rates are high

If the Reserve Bank's official cash rate is 1.5 per cent and home loans are 4.4 per cent, why are credit card rates as high as 20 per cent?

It was the question that had the new Reserve Bank governor Philip Lowe stumped.

On Thursday he confessed before the Parliament's economics committee: "I wish I knew the answer to that".

"If you ask the same questions in your subsequent hearings, I will be interested in the answers," he added. His usual reply would have been that given time competition will sort it out. But it doesn't, for credit cards.

The Reserve Bank's own figures show that 20 years ago the average rate on a standard credit card was 16.8 per cent. Ten years on, it was 17.3 per cent. Today it's 19.75 per cent. It's gone up, in the same period in which the standard home loan rate has fallen from 9 to 8 to 5.25 per cent, and the discount rate to 4.4 per cent. The cash rate has slid from 7 to 6 to 1.5 per cent.

The banks will say in their defence that they also offer low-rate cards for which they charge a fee, but the rates on those cards have also gone up. Ten years ago the average low-rate card charged 10.8 per cent. Now it's 12.7 per cent.

Lowe's best guess is that banks choose not to compete on rates, believing they didn't need to. "Consumers, for whatever reason, when selecting a credit card, are not particularly sensitive to the interest rate," he said. "They often want to get a one-year interest-free period, they are quite sensitive to that, they are quite sensitive to reward points."

He's right about not being sensitive to rates. I don't have a clue what mine is. But I've signed for cards that offer points (before abandoning the idea because I thought it was silly) and I once signed up for a card because it had a really neat design. When a US bank renamed one of its cards the "Elvis card" a few decades back its takeup rate tripled.

The best guess as to why most of us don't much care about rates comes from studies that find that alongside the sizeable proportion of the population that pays off its cards on time (and so doesn't care about rates) is a larger group of "deluded optimists" who believe they will pay their cards off on time. They're not concerned about rates either because they falsely believe they won't have to pay them. Psychological tests show the more likely people are to select cards with high rates, the more optimistic they are about all things.

Which just leaves the realistic pessimists, who know they'll have trouble and are right. The banks don't much want them; there's a genuine chance they won't get paid. So they screen them out by charging higher rates than their competitors, which leads to a sort-of race to the top, which is what we've had. Now what we need is a way out.

In The Age and Sydney Morning Herald