Credit Card Policies for Allocating Payments: Its Impact on Risk-Based Pricing and Comprehension by Consumers (2009)

Abstract Credit card borrowers can have balances on the same card at several different rates at once. By choosing a favorable method of allocating payments to balances, issuers can substantially raise the interest rates paid by borrowers. The impact of this policy on risk-based pricing is examined using computer-simulated accounts. It is found that the prevailing policy used by issuers causes inverse risk-based pricing. In addition, a survey shows that few credit card users understand the impact of payment allocation. The impact of recent legislation on payment allocation policy is also examined. © 2009 Academy of Financial Services. All rights reserved. JEL classification: G21; G28; Ll3 Keywords: Credit cards; Payment; Allocation; Pricing 1. Introduction Credit cards are very unusual among loan products in that consumers pay one amount that is then applied to several balances at different rates. A consumer can have multiple loan balances outside of a credit card with a single lender such as mortgage, a home equity line, and a car loan with a single bank. However, that consumer will typically make a separate payment for each loan product. If they pay above the minimum amount, that consumer can then easily choose which balance to pay down first, often choosing to pay the highest interest rate loan first. However, a credit card borrower with a separate cash advance, purchase and low-rate short-term promotion balance does not get to choose how their payment is applied. The credit card company chooses. Credit card issuers almost universally choose to apply payments to the lowest interest rate balance first (from here on out this policy will be referred to as for lowest rate first). In fact, a United States Government Accountability Office study (2006) found that 23 of 28 issuers in the survey explicitly had this policy. The other five issuers applied payments subject to their discretion, suggesting it is possible that all of these remaining issuers used the same methodology without explicitly stating the policy. In fact, after an extensive search, we were only able to find three issuers that explicitly apply payments using a method other than LRF. One is State Employee's Credit Union in North Carolina, another is a bankcard offered by Nordstrom' s, and the third is an issuer in the United Kingdom named Nationwide.1 Although the use of a payment allocation policy that maximizes interest rates may seem like an obvious choice by issuers, if markets are efficient, the prevalence of this policy is by no means a given. With perfect market efficiency, rational borrowers would see that the LRF policy is equivalent to an indirect rate increase, and would be indifferent between low stated rates with an unfavorable payment allocation policy and higher stated rates combined with a more favorable payment allocation policy. Therefore, there is no compelling reason for issuers in an efficient market to universally favor this policy. In fact, if all policies are equally efficient, given that the impact of payment allocation policy depends on the details of account dynamics, one may expect a heterogeneous market that includes a variety of policies to satisfy consumer preferences. However, all payment policies may not be equally efficient, because the dynamics of account charges and payments are closely related to risk. If different policies had different implications for the risk-price relationship, in an efficient market issuers would choose the policy that produces the strongest risk-based pricing. This research is the first to test the nature of the risk-price relationship under various policies, with important implications for the efficiency of the credit card market. Depending on the dynamics of a particular customer, payment allocation can be very powerful at indirectly increasing the interest rate. If a borrower uses both cash advances and purchases, LRF over time converts all their balance to the cash advance rate and the faster they make payments, the quicker their balance moves to the higher rate. …