Credit card interest

Overview

Credit card interest is a way in which credit card issuers generate revenue. A card issuer is a bank or credit union that gives a consumer (the cardholder) a card or account number that can be used with various payees to make payments and borrow money from the bank simultaneously. The bank pays the payee and then charges the cardholder interest over the time the money remains borrowed. Banks suffer losses when cardholders do not pay back the borrowed money as agreed. As a result, optimal calculation of interest based on any information they have about the cardholder's credit risk is key to a card issuer's profitability. Before determining what interest rate to offer, banks typically check national, and international (if applicable), credit bureau reports to identify the borrowing history of the card holder applicant with other banks and conduct detailed interviews and documentation of the applicant's finances.

Interest rates

Interest rates vary widely. Some credit card loans are secured by real estate, and can be as low as 6 to 12% in the U.S. (2005). Typical credit cards have interest rates between 7 and 36% in the U.S., depending largely upon the bank's risk evaluation methods and the borrower's credit history. Brazil has much higher interest rates, about 50% over that of most developing countries, which average about 200% (Economist, May 2006). A Brazilian bank-issued Visa or MasterCard to a new account holder can have annual interest as high as 240% even though inflation seems to have gone up per annum (Economist, May 2006). Banco do Brasil offered its new checking account holders Visa and MasterCard credit accounts for 192% annual interest, with somewhat lower interest rates reserved for people with dependable income and assets (July 2005). These high-interest accounts typically offer very low credit limits (US$40 to $400). They also often offer a grace period with no interest until the due date, which makes them more popular for use as liquidity accounts, which means that the majority of consumers use them only for convenience to make purchases within the monthly budget, and then (usually) pay them off in full each month. As of August 2016, Brazilian rates can get as high as 450% per year.

Calculation of interest rates

Most U.S. credit cards are quoted in terms of nominal annual percentage rate (APR) compounded daily, or sometimes (and especially formerly) monthly, which in either case is not the same as the effective annual rate (EAR). Despite the "annual" in APR, it is not necessarily a direct reference for the interest rate paid on a stable balance over one year. The more direct reference for the one-year rate of interest is EAR. The general conversion factor for APR to EAR is

E A R = ( 1 +

A P R

n

)

n

− 1

{\displaystyle EAR=(1+{APR \over n})^{n}-1}

, where

n

{\displaystyle n}

represents the number of compounding periods of the APR per EAR period. For a common credit card quoted at 12.99% APR compounded daily, the one-year EAR is

( 1 +

0.1299 365

)

365

− 1

{\displaystyle (1+{0.1299 \over 365})^{365}-1}

, or 13.87%; and if it is compounded monthly, the one-year EAR is

( 1 +

Interrelated fees

Banks make many other fees that interrelate with interest charges in complex ways (since they make a profit from the whole combination), including transactions fees paid by merchants and cardholders, and penalty fees, such as for borrowing over the established credit limit, or for failing to make a minimum payment on time. Banks vary widely in the proportion of credit card account income that comes from interest (depending upon their marketing mix). In a typical UK card issuer, between 80% and 90% of cardholder generated income is derived from interest charges. A further 10% is made up from default fees.

Usury

Many nations limit the amount of interest that can be charged (often called usury laws). Most countries strictly regulate the manner in which interest rates are agreed, calculated, and disclosed. Some countries (especially with Muslim influence) prohibit interest being charged at all (and other methods are used, such as an ownership interest taken by the bank in the cardholder's business profits based upon the purchase amount).

Credit CARD Act of 2009

This statute covers several aspects of credit card contracts, including the following:

Limits over-the-limit fees to cases where the consumer has given permission. Limits interest rate increases on past balances to cases in which the account has been over 60 days late. Limits general interest rate increases to 45 days after a written notice is given, allowing the consumer to opt out. Requires extra payments to be applied to the highest-interest rate sub-balance.

Truth in Lending Act

In the United States, there are four commonly accepted methods of charging interest, which are listed in the section below, "Methods of Charging Interest". These are detailed in Regulation Z of the Truth in Lending Act. There is a legal obligation on U.S. issuers that the method of charging interest is disclosed and is sufficiently transparent to be fair. This is typically done in the Schumer box, which lists rates and terms in writing to the cardholder applicant in a standard format. Regulation Z details four principal methods of calculating interest. For purposes of comparison between rates, the "expected rate" is the APR applied to the average daily balance for a year, or in other words, the interest charged on the actual balance left lent out by the bank at the close of each business day. That said, there are not just four prescribed ways to charge interest, to wit those specified in Regulation Z. U.S. issuers can charge interest according to any reasonable method to which the card holder agrees. The four (or arguably six) "safe-harbour" ways to describe and charge interest are detailed in Regulation Z. If an issuer charges interest in one of these ways then there is a shorthand description of that method in Regulation Z that can be used. If a lender uses that description, and charges interest in that way, then their disclosure is deemed to be sufficiently transparent and fair. If not, then they must provide an explanation of the method used. Because of the safe-harbour definitions, U.S. lenders have tended to gravitate towards these methods of charging and describing the way interest is charged, both because it is easy and because legal compliance is guaranteed. Arguably, the approach also provides flexibility for issuers, enhancing the profile of the way in which interest is charged, and therefore increasing the scope for product differentiation on what is, after all, a key product feature.

Pre-payment penalties

Clauses calling for a penalty for paying more than the contracted regular payment were once common in another type of loan, the installment loan, and they are of great concern to governments regulating credit card loans. Today, in many cases because of strict laws, most card issuers do not charge any pre-payment penalties at all (except those that come naturally from the interest calculation method – see the section below). That means cardholders can "cancel" the loan at any time by simply paying it off, and be charged no more interest than that calculated on the time the money was borrowed.

Cancelling loans

Cardholders are often surprised in situations where the bank cancels or changes the terms on their loans. Most card issuers are allowed to raise the interest rate (within legal guidelines) at any time. Usually they have to give some notice, such as 30 or 60 days, in writing. If the cardholder does not agree to the new rate or terms, then it is expected that the account will be paid off. That can be difficult for a cardholder with a large loan who expected to make payments over many years. Banks can also cancel a loan and request that all amounts be paid back immediately for any default on the contract whatsoever, which could be as simple as a late payment or even a default on a loan to another bank (the so-called "Universal default") if the contract states it. In some cases, a borrower may cancel the account within the time allowed without paying off the account. As long as the borrower makes no new charges on the account, then the borrower has not "agreed" to the new terms, and may pay off the account under the old terms.

Average daily balance

The sum of the daily outstanding balances is divided by the number of days covered in the cycle to give an average balance for that period. This amount is multiplied by a constant factor to give an interest charge. The resultant interest is the same as if interest was charged at the close of each day, except that it compounds (gets added to the principal) only once per month. It is the simplest of the four methods in the sense that it produces an interest rate approximating if not exactly equal the expected rate.

Adjusted balance

The balance at the end of the billing cycle is multiplied by a factor in order to give the interest charge. This can result in an actual interest rate lower or higher than the expected one, since it does not take into account the average daily balance, i.e. the time value of money actually lent by the bank. It does, however, take into account money that is left lent out over several months.

Previous balance

The reverse happens: the balance at the start of the previous billing cycle is multiplied by the interest factor in order to derive the charge. As with the Adjusted Balance method, this method can result in an interest rate higher or lower than the expected one, but the part of the balance that carries over more than two full cycles is charged at the expected rate.