Rising interest rates are providing welcome relief to savers. As previously reported, earning at least a 2% APY on your savings from an FDIC insured bank account is now much easier. However, rising rates will make borrowing more expensive for people in debt. Credit card debt is set to become particularly expensive. According to a recent report from CompareCards by LendingTree (which owns MagnifyMoney, where I work), the average annual percentage rate (APR) on credit card debt reached 15.32% in March, an 18-year high. Most credit card contracts have variable interest rates and are tied to the prime rate. More worrying is that the spread (the difference between the prime rate and the average APR) has increased to 10.5%, compared to a 6% spread in 2000. As the prime rate continues to increase, we can expect credit card interest rates to reach historic highs. In this post, I will review:
The history of the average credit card average annual percentage rate. This is the rate charged on accounts that are assessed interest each period. Credit card companies use risk-based pricing, which means the better your credit score the lower your rate. For example, a standard Bank of America credit card offers an interest rate range (as of publication date) of 14.49% – 24.49%. People with the best credit scores would get closer to 14.49%, whereas people with the worst scores would get close to 24.49% (if they can get approved).
Credit Card Spreads: Much Higher Than Before
Most credit card contracts offer variable interest rates that are tied to the prime rate. The prime rate is highly correlated to the federal funds rate. As a result, when the Federal Reserve increases the target federal funds rate, credit card accounts experience an almost immediate increase in rates. However, the chart above shows a rapid increase in credit card interest rates in 2009 – when the federal funds rate was not increasing. These rate hikes increased the spread, which means credit cards interest rates will reach historic highs as the Fed continues to hike rates.
The CARD Act, implemented in 2010, had a dramatic impact on the industry. One of the biggest changes was a restriction of a bank’s ability to risk-base reprice existing customers. Prior to the act, credit card companies could regularly review customers’ credit risk profiles. If the risk profile deteriorated, credit card companies would be able to increase the interest rate on the existing balance. For example, a customer could have opened a credit card account when she had a FICO of 750 and received a low interest rate. Over time, the hypothetical borrower’s situation deteriorated and credit score declined. Credit card companies would have been able to reprice the existing balance, even if the borrower was making payments on time. And a missed payment with one credit card company could lead to increased pricing on all credit cards (this was frequently referred to as a universal default).
Credit card companies are now limited in their ability to change the pricing in real time. This rule went into effect in 2010. To compensate, many credit card companies repriced a significant portion of their portfolio prior to the enactment of the law. The inability of credit card companies to reprice in real time means that people with excellent credit will pay higher rates than the historic average. However, people whose situation deteriorates will no longer see interest rate hikes.
In addition, losses during the Great Recession came in much higher than expected. Pricing models are based upon expected loss rates and volatility. Given the higher volatility of credit card portfolios, banks had to adjust their pricing models.
For consumers with credit card debt, there are still a number of options to find a lower interest rate. Here are two options to consider:
Balance Transfer Offers: Despite the rising rates, banks continue to advertise potentially lucrative balance transfer offers. Search online for the best balance transfer credit cards at sites like NerdWallet or CompareCards. Or, you might only need to respond to an offer in your mailbox: credit card companies frequently send out balance transfer offers with a check. Balance transfers are typically only available to people with good or excellent credit.
Personal Loans: The personal loan market has been growing exponentially, and it can be particularly useful for people with bigger balances or slightly worse credit scores. With most online lenders, you can check your rate without hurting your score. Shop online for personal loans at sites like CreditKarma.
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