Chapter 7 - Solutions for a Financial Crisis

In a recent study published by Harvard Law School, Angela K. Littwin examined the use of various credit sources among low-income individuals. Her goal was to figure out whether or not restrictions on credit card lending would affect low-income borrowers’ access to other credit sources. Her findings reveal some interesting patterns.

Why Credit Cards are Important

Since a 1978 Supreme Court ruling, limits on credit card interest rates have been determined by the laws of the state in which the card issuer’s headquarters are located. This allows credit card companies to set up headquarters in states with higher interest rate caps, so they can charge card users around the country more interest.

Twenty-seven years later, in 2005, Congress passed BAPCPA, the new bankruptcy laws that effectively made discharging credit card debt harder for bankruptcy petitioners. Not surprisingly, credit card companies invested hundreds of millions of dollars lobbying for these changes.

The result of all this is that credit card companies located in states without interest rate limits can charge absurdly high interest
rates without risking much of anything, since filers are less likely to have their credit card debt excused during bankruptcy cases.
But the consumer disadvantage might go even further. According to Littwin’s research, the generally accepted belief that credit card restrictions and reforms (such as usury caps and regulation of penalty fees) would harm card users because of the substitution effect might not hold true.

The Substitution Effect

Apparently, traditional thinking holds that, if restrictions on credit cards made them less available to low-income borrowers, those borrowers would turn to other, more expensive sources of credit such as pawn shops, payday lenders, rent-to-own stores and more.

This is considered unfavorable because many “fringe” or “alternative” lenders charge higher interest rates and fees and come with less borrower-friendly terms than credit cards. This line of thinking leads to the conclusion that low-income borrowers actually save money by borrowing with credit cards (because they’re not borrowing from more expensive sources). For this theory to be correct, according to Littwin, these credit sources must be interchangeable and credit cards must not be the least desirable source of credit.

But Littwin’s research suggests that these two conditions aren’t in place, meaning that the substitution effect of credit sources may not be as powerful as it has generally been believed to be. The results, in fact, suggest that most low-income borrowers actually would benefit from credit card restriction and/or reform.

The “Temptation” Effect of Credit Cards

Perhaps the most intriguing element of Littwin’s study was the “temptation” effect of credit cards her subjects reported. Littwin makes reference to previous studies that have found shoppers willing to pay higher prices for items when credit cards or credit card insignia are present.

The individuals Littwin interviewed confirmed those results, and added that they felt “tempted” to spend money when they knew they had a credit card at their disposal.

These findings may not come as a surprise – the promise of getting something in the present and not having to worry about payment until the vague and undefined future may be too good to pass up. But this very feature was why Littwin’s subjects ultimately rated credit cards as one of the least favorable forms of credit, including rent-to-own stores and pawn shops.

It seems Littwin’s subjects ultimately disliked credit cards because they didn’t have a complete understanding of the terms of their credit card loans at the time they made their purchases. Littwin even suggests that credit card companies encourage this delayed understanding, since many card issuers:

• Display the “minimum payment” more prominently than total amount due on bills;
• Advertise introductory (teaser) rates that reset after a certain time period; and
• Create terms and conditions that cover several pages in small font, discouraging users to read and understand them thoroughly.

Littwin even noticed that her subjects tended to follow similar cycles with their credit card use:

1. Getting a credit card (for emergency use, purchasing power, improvement of credit score or curiosity);
2. Experiencing “temptation,” using the card for purchases without paying off full monthly balance;
3. Failing to meet minimum payments and/or finding that an issuer refuses to raise credit limit.

Once subjects completed the cycle, they generally focused on paying off their debt, which had driven many into financial ruin. Littwin noted that many subjects inquired about filing for bankruptcy during her interviews.

Because the “temptation to spend” associated with credit cards does not apply to other sources of credit, Littwin concluded that the substitution effect of credit cards is much less influential than once believed. Other credit sources (such as pawn shops) allow borrowers to be familiar with the terms of their loans at the outset and prohibit borrowers from borrowing outside of their means.

Are Credit Cards Too Unmanageable?

Littwin’s subjects rated credit cards extremely low for the quality of “transparency” or “manageability,” which was largely the reason they were ultimately unhappy with credit cards as a credit source.

Littwin suggests credit card reform that would give credit card users a greater variety of options when paying off their credit card debt to help users better understand the terms of their cards and avoid serious debt in the future.