Credit Cards: Increased Complexity in Rates and Fees Heightens Need for More Effective Disclosures to Consumers
Published: 2006-09-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: With credit card penalty rates and fees now common, the Federal Reserve has begun efforts to revise disclosures to better inform consumers of these costs. Questions have also been raised about the relationship among penalty charges, consumer bankruptcies, and issuer profits. GAO examined (1) how card fees and other practices have evolved and how cardholders have been affected, (2) how effectively these pricing practices are disclosed to cardholders, (3) the extent to which penalty charges contribute to cardholder bankruptcies, and (4) card issuers' revenues and profitability. Among other things, GAO analyzed disclosures from popular cards; obtained data on rates and fees paid on cardholder accounts from 6 large issuers; employed a usability consultant to analyze and test disclosures; interviewed a sample of consumers selected to represent a range of education and income levels; and analyzed academic and regulatory studies on bankruptcy and card issuer revenues.
section_title: What GAO Found
paragraphs: Originally having fixed interest rates around 20 percent and few fees, popular credit cards now feature a variety of interest rates and other fees, including penalties for making late payments that have increased to as high as $39 per occurrence and interest rates of over 30 percent for cardholders who pay late or exceed a credit limit. Issuers explained that these practices represent risk-based pricing that allows them to offer cards with lower costs to less risky cardholders while providing cards to riskier consumers who might otherwise be unable to obtain such credit. Although costs can vary significantly, many cardholders now appear to have cards with lower interest rates than those offered in the past; data from the top six issuers reported to GAO indicate that, in 2005, about 80 percent of their accounts were assessed interest rates of less than 20 percent, with over 40 percent having rates below 15 percent. The issuers also reported that 35 percent of their active U.S. accounts were assessed late fees and 13 percent were assessed over-limit fees in 2005. Although issuers must disclose information intended to help consumers compare card costs, disclosures by the largest issuers have various weaknesses that reduced consumers' ability to use and understand them. According to a usability expert's review, disclosures from the largest credit card issuers were often written well above the eighth-grade level at which about half of U.S. adults read. Contrary to usability and readability best practices, the disclosures buried important information in text, failed to group and label related material, and used small typefaces. Perhaps as a result, cardholders that the expert tested often had difficulty using the disclosures to find and understand key rates or terms applicable to the cards. Similarly, GAO's interviews with 112 cardholders indicated that many failed to understand key aspects of their cards, including when they would be charged for late payments or what actions could cause issuers to raise rates. These weaknesses may arise from issuers drafting disclosures to avoid lawsuits, and from federal regulations that highlight less relevant information and are not well suited for presenting the complex rates or terms that cards currently feature. Although the Federal Reserve has started to obtain consumer input, its staff recognizes the challenge of designing disclosures that include all key information in a clear manner. Although penalty charges reduce the funds available to repay cardholders' debts, their role in contributing to bankruptcies was not clear. The six largest issuers reported that unpaid interest and fees represented about 10 percent of the balances owed by bankrupt cardholders, but were unable to provide data on penalty charges these cardholders paid prior to filing for bankruptcy. Although revenues from penalty interest and fees have increased, profits of the largest issuers have been stable in recent years. GAO analysis indicates that while the majority of issuer revenues came from interest charges, the portion attributable to penalty rates has grown.

section_title: Letter
paragraphs: Over the past 25 years, the prevalence and use of credit cards in the United  States has grown dramatically. Between 1980 and 2005, the amount that  U.S. consumers charged to their cards grew from an estimated $69 billion  per year to more than $1.8 trillion, according to one firm that analyzes the  card industry. This firm also reports that the number of U.S. credit cards  issued to consumers now exceeds 691 million. The increased use of credit  cards has contributed to an expansion in household debt, which grew from  $59 billion in 1980 to roughly $830 billion by the end of 2005. The Board of  Governors of the Federal Reserve System (Federal Reserve) estimates that  in 2004, the average American household owed about $2,200 in credit card  debt, up from about $1,000 in 1992.
Generally, a consumer’s cost of using a credit card is determined by the  terms and conditions applicable to the card—such as the interest rate(s),  minimum payment amounts, and payment schedules, which are typically  presented in a written cardmember agreement—and how a consumer uses  a card. The Federal Reserve, under the Truth in Lending Act (TILA), is  responsible for creating and enforcing requirements relating to the  disclosure of terms and conditions of consumer credit, including those  applicable to credit cards. The regulation that implements TILA’s  requirements is the Federal Reserve’s Regulation Z. As credit card use and  debt have grown, representatives of consumer groups and issuers have  questioned the extent to which consumers understand their credit card  terms and conditions, including issuers’ practices that—even if permitted  under applicable terms and conditions—could increase consumers’ costs  of using credit cards. These practices include the application of fees or  relatively high penalty interest rates if cardholders pay late or exceed credit  limits. Issuers also can allocate customers’ payments among different  components of their outstanding balances in ways that maximize total  interest charges. Although card issuers have argued that these practices are  appropriate because they compensate for the greater risks posed by  cardholders who make late payments or exhibit other risky behaviors,  consumer groups say that the fees and practices are harmful to the  financial condition of many cardholders and that card issuers use them to  generate profits.
You requested that we review a number of issues related to credit card fees  and practices, specifically of the largest issuers of credit cards in the  United States. This report discusses (1) how the interest, fees, and other  practices that affect the pricing structure of cards from the largest U.S.  issuers have evolved and cardholders’ experiences under these pricing  structures in recent years; (2) how effectively the issuers disclose the  pricing structures of cards to their cardholders (3) whether credit card debt  and penalty interest and fees contribute to cardholder bankruptcies; and  (4) the extent to which penalty interest and fees contribute to the revenues  and profitability of issuers’ credit card operations.
To identify the pricing structures of cards—including their interest rates,  fees, and other practices—we analyzed the cardmember agreements, as  well as materials used by the six largest issuers as of December 31, 2004,  for 28 popular cards used to solicit new credit card customers from 2003  through 2005. To determine the extent to which these issuers’ cardholders  were assessed interest and fees, we obtained data from each of the six  largest issuers about their cardholder accounts and their operations. To  protect each issuer’s proprietary information, a third-party organization,  engaged by counsel to the issuers, aggregated these data and then provided  the results to us. Although the six largest issuers whose accounts were  included in this survey and whose cards we reviewed may include some  subprime accounts, we did not include information in this report relating to  cards offered by credit card issuers that engage primarily in subprime  lending. To assess the effectiveness of the disclosures that issuers provide  to cardholders in terms of their usability or readability, we contracted with  a consulting firm that specializes in assessing the readability and usability  of written and other materials to analyze a representative selection of the  largest issuers’ cardmember agreements and solicitation materials,  including direct mail applications and letters, used for opening an account  (in total, the solicitation materials for four cards and cardmember  agreements for the same four cards). The consulting firm compared these  materials to recognized industry guidelines for readability and presentation  and conducted testing to assess how well cardholders could use the  materials to identify and understand information about these credit cards.  While the materials used for the readability and usability assessments  appeared to be typical of the large issuers’ disclosures, the results cannot  be generalized to materials that were not reviewed. We also conducted  structured interviews to learn about the card-using behavior and  knowledge of various credit card terms and conditions of 112 consumers  recruited by a market research organization to represent a range of adult  income and education levels. However, our sample of cardholders was too  small to be statistically representative of all cardholders, thus the results of  our interviews cannot be generalized to the population of all U.S.  cardholders. We also reviewed comment letters submitted to the Federal  Reserve in response to its comprehensive review of Regulation Z’s open- end credit rules, including rules pertaining to credit card disclosures. To  determine the extent to which credit card debt and penalty interest and  fees contributed to cardholder bankruptcies, we analyzed studies, reports,  and bank regulatory data relating to credit card debt and consumer  bankruptcies, as well as information reported to us as part of the data  request to the six largest issuers. To determine the extent to which penalty  interest and fees contributes to card issuers’ revenues and profitability, we  analyzed publicly available sources of revenue and profitability data for  card issuers, including information included in reports filed with the  Securities and Exchange Commission and bank regulatory reports, in  addition to information reported to us as part of the data request to the six  largest issuers. In addition, we spoke with representatives of other U.S.  banks that are large credit card issuers, as well as representatives of  consumer groups, industry associations, academics, organizations that  collect and analyze information on the credit card industry, and federal  banking regulators. We also reviewed research reports and academic  studies of the credit card industry.
We conducted our work from June 2005 to September 2006 in Boston;  Chicago; Charlotte, North Carolina; New York City; San Francisco;  Wilmington, Delaware; and Washington, D.C., in accordance with generally  accepted government auditing standards. Appendix I describes the  objectives, scope, and methodology of our review in more detail.
subsections: section_title: Background
paragraphs: Credit card use has grown dramatically since the introduction of cards  more than 5 decades ago. Cards were first introduced in 1950, when Diners  Club established the first general-purpose charge card that allowed its  cardholders to purchase goods and services from many different  merchants. In the late 1950s, Bank of America began offering the first  widely available general purpose credit card, which, unlike a charge card  that requires the balance to be paid in full each month, allows a cardholder  to make purchases up to a credit limit and pay the balance off over time. To  increase the number of consumers carrying the card and to reach retailers  outside of Bank of America’s area of operation, other banks were given the  opportunity to license Bank of America’s credit card. As the network of  banks issuing these credit cards expanded internationally, administrative  operations were spun off into a separate entity that evolved into the Visa  network. In contrast to credit cards, debit cards result in funds being  withdrawn almost immediately from consumers’ bank accounts (as if they  had a written a check instead). According to CardWeb.com, Inc., a firm that  collects and analyzes data relating to the credit card industry, the number  of times per month that credit or debit cards were used for purchases or  other transactions exceeded 2.3 billion in May 2003, the last month for  which the firm reported this data.
The number of credit cards in circulation and the extent to which they are  used has also grown dramatically. The range of goods and services that can  be purchased with credit cards has expanded, with cards now being used  to pay for groceries, health care, and federal and state income taxes. As  shown in figure 1, in 2005, consumers held more than 691 million credit  cards and the total value of transactions for which these cards were used  exceeded $1.8 trillion.
The largest issuers of credit cards in the United States are commercial  banks, including many of the largest banks in the country. More than 6,000  depository institutions issue credit cards, but, over the past decade, the  majority of accounts have become increasingly concentrated among a  small number of large issuers. Figure 2 shows the largest bank issuers of  credit cards by their total credit card balances outstanding as of December  31, 2004 (the most recent data available) and the proportion they represent  of the overall total of card balances outstanding.
TILA is the primary federal law pertaining to the extension of consumer  credit. Congress passed TILA in 1968 to provide for meaningful disclosure  of credit terms in order to enable consumers to more easily compare the  various credit terms available in the marketplace, to avoid the uninformed  use of credit, and to protect themselves against inaccurate and unfair credit  billing and credit card practices. The regulation that implements TILA’s  requirements is Regulation Z, which is administered by the Federal  Reserve.
Under Regulation Z, card issuers are required to disclose the terms and  conditions to potential and existing cardholders at various times. When  first marketing a card directly to prospective cardholders, written or oral  applications or solicitations to open credit card accounts must generally  disclose key information relevant to the costs of using the card, including  the applicable interest rate that will be assessed on any outstanding  balances and several key fees or other charges that may apply, such as the  fee for making a late payment. In addition, issuers must provide  consumers with an initial disclosure statement, which is usually a  component of the issuer’s cardmember agreement, before the first  transaction is made with a card. The cardmember agreement provides  more comprehensive information about a card’s terms and conditions than  would be provided as part of the application or a solicitation letter.
In some cases, the laws of individual states also can affect card issuers’  operations. For example, although many credit card agreements permit  issuers to make unilateral changes to the agreement’s terms and  conditions, some state laws require that consumers be given the right to  opt out of changes. However, as a result of the National Bank Act, and its  interpretation by the U.S. Supreme Court, the interest and fees charged by  a national bank on credit card accounts is subject only to the laws of the  state in which the bank is chartered, even if its lending activities occur  outside of its charter state. As a result, the largest banks have located  their credit card operations in states with laws seen as more favorable for  the issuer with respect to credit card lending.
Various federal agencies oversee credit card issuers. The Federal Reserve  has responsibility for overseeing issuers that are chartered as state banks  and are also members of the Federal Reserve System. Many card issuers  are chartered as national banks, which OCC supervises. Other regulators of  bank issuers are FDIC, which oversees state-chartered banks with federally  insured deposits that are not members of the Federal Reserve System; the  Office of Thrift Supervision, which oversees federally chartered and state- chartered savings associations with federally insured deposits; or the  National Credit Union Administration, which oversees federally-chartered  and state-chartered credit unions whose member accounts are federally  insured. As part of their oversight, these regulators review card issuers’  compliance with TILA and ensure that an institution’s credit card  operations do not pose a threat to the institutions’ safety and soundness.  The Federal Trade Commission generally has responsibility for enforcing  TILA and other consumer protection laws for credit card issuers that are  not depository institutions.
section_title: Credit Card Fees and Issuer Practices That Can Increase Cardholder Costs Have Expanded, but a Minority of Cardholders Appear to Be Affected
paragraphs: Prior to about 1990, card issuers offered credit cards that featured an  annual fee, a relatively high, fixed interest rate, and low penalty fees,  compared with average rates and fees assessed in 2005. Over the past 15  years, typical credit cards offered by the largest U.S. issuers evolved to  feature more complex pricing structures, including multiple interest rates  that vary with market fluctuations. The largest issuers also increased the  number, and in some cases substantially increased the amounts, of fees  assessed on cardholders for violations of the terms of their credit  agreement, such as making a late payment. Issuers said that these changes  have benefited a greater number of cardholders, whereas critics contended  that some practices unfairly increased cardholder costs. The largest six  issuers provided data indicating that most of their cardholders had interest  rates on their cards that were lower than the single fixed rates that  prevailed on cards prior to the 1990s and that a small proportion of  cardholders paid high penalty interest rates in 2005. In addition, although  most cardholders did not appear to be paying penalty fees, about one-third  of the accounts with these largest issuers paid at least one late fee in 2005.
subsections: section_title: Issuers Have Developed More Complex Credit Card Pricing Structures
paragraphs: The interest rates, fees, and other practices that represent the pricing  structure for credit cards have become more complex since the early  1990s. After first being introduced in the 1950s, for the next several  decades, credit cards commonly charged a single fixed interest rate around  20 percent—as the annual percentage rate (APR)—which covered most of  an issuer’s expenses associated with card use. Issuers also charged  cardholders an annual fee, which was typically between $20 and $50  beginning in about 1980, according to a senior economist at the Federal  Reserve Board. Card issuers generally offered these credit cards only to the  most creditworthy U.S. consumers. According to a study of credit card  pricing done by a member of the staff of one of the Federal Reserve Banks,  few issuers in the late 1980s and early 1990s charged cardholders fees as  penalties if they made late payments or exceeded the credit limit set by the  issuer. Furthermore, these fees, when they were assessed, were relatively  small. For example, the Federal Reserve Bank staff member’s paper notes  that the typical late fee charged on cards in the 1980s ranged from $5 to  $10.
subsections: section_title: Multiple Interest Rates May Apply to a Single Account and May Change Based on Market Fluctuations
paragraphs: After generally charging just a single fixed interest rate before 1990, the  largest issuers now apply multiple interest rates to a single card account  balance and the level of these rates can vary depending on the type of  transaction in which a cardholder engages. To identify recent pricing trends  for credit cards, we analyzed the disclosures made to prospective and  existing cardholders for 28 popular credit cards offered during 2003, 2004,  and 2005 by the six largest issuers (based on credit card balances  outstanding at the end of 2004). At that time, these issuers held almost 80  percent of consumer debt owed to credit card issuers and as much as 61  percent of total U.S. credit card accounts. As a result, our analysis of these  28 cards likely describes the card pricing structure and terms that apply to  the majority of U.S. cardholders. However, our sample of cards did not  include subprime cards, which typically have higher cost structures to  compensate for the higher risks posed by subprime borrowers.
We found that all but one of these popular cards assessed up to three  different interest rates on a cardholder’s balance. For example, cards  assessed separate rates on  balances that resulted from the purchase or lease of goods and services,  such as food, clothing, and home appliances;   balances that were transferred from another credit card, which  cardholders may do to consolidate balances across cards to take  advantage of lower interest rates; and  balances that resulted from using the card to obtain cash, such as a  withdrawal from a bank automated teller machine.
In addition to having separate rates for different transactions, popular  credit cards increasingly have interest rates that vary periodically as  market interest rates change. Almost all of the cards we analyzed charged  variable rates, with the number of cards assessing these rates having  increased over the most recent 3-year period. More specifically, about 84  percent of cards we reviewed (16 of 19 cards) assessed a variable interest  rate in 2003, 91 percent (21 of 23 cards) in 2004, and 93 percent (25 of 27  cards) in 2005. Issuers typically determine these variable rates by taking  the prevailing level of a base rate, such as the prime rate, and adding a fixed  percentage amount. In addition, the issuers usually reset the interest rates  on a monthly basis.
Issuers appear to have assessed lower interest rates in recent years than  they did prior to about 1990. Issuer representatives noted that issuers used  to generally offer cards with a single rate of around 20 percent to their  cardholders, and the average credit card rates reported by the Federal  Reserve were generally around 18 percent between 1972 and 1990.  According to the survey of credit card plans, conducted every 6 months by  the Federal Reserve, more than 100 card issuers indicated that these  issuers charged interest rates between 12 and 15 percent on average from  2001 to 2005. For the 28 popular cards we reviewed, the average interest  rate that would be assessed for purchases was 12.3 percent in 2005, almost  6 percentage points lower than the average rates that prevailed until about  1990. We found that the range of rates charged on these cards was between  about 8 and 19 percent in 2005. The average rate on these cards climbed  slightly during this period, having averaged about 11.5 percent in 2003 and  about 12 percent in 2004, largely reflecting the general upward movement  in prime rates. Figure 3 shows the general decline in credit card interest  rates, as reported by the Federal Reserve, between about 1991 and 2005  compared with the prime rate over this time. As these data show, credit  card interest rates generally were stable regardless of the level of market  interest rates until around 1996, at which time changes in credit card rates  approximated changes in market interest rates. In addition, the spread  between the prime rate and credit card rates was generally wider in the  period before the 1980s than it has been since 1990, which indicates that  since then cardholders are paying lower rates in terms of other market  rates.
Recently, many issuers have attempted to obtain new customers by offering  low, even zero, introductory interest rates for limited periods. According to  an issuer representative and industry analyst we interviewed, low  introductory interest rates have been necessary to attract cardholders in  the current competitive environment where most consumers who qualify  for a credit card already have at least one. Of the 28 popular cards that we  analyzed, 7 cards (37 percent) offered prospective cardholders a low  introductory rate in 2003, but 20 (74 percent) did so in 2005—with most  rates set at zero for about 8 months. According to an analyst who studies  the credit card industry for large investors, approximately 25 percent of all  purchases are made with cards offering a zero percent interest rate.
Increased competition among issuers, which can be attributed to several  factors, likely caused the reductions in credit card interest rates. In the  early 1990s, new banks whose operations were solely focused on credit  cards entered the market, according to issuer representatives. Known as  monoline banks, issuer representatives told us these institutions competed  for cardholders by offering lower interest rates and rewards, and expanded  the availability of credit to a much larger segment of the population. Also,  in 1988, new requirements were implemented for credit card disclosures  that were intended to help consumers better compare pricing information  on credit cards. These new requirements mandated that card issuers use a  tabular format to provide information to consumers about interest rates  and some fees on solicitations and applications mailed to consumers.  According to issuers, consumer groups, and others, this format, which is  popularly known as the Schumer box, has helped to significantly increase  consumer awareness of credit card costs. According to a study authored  by a staff member of a Federal Reserve Bank, consumer awareness of  credit card interest rates has prompted more cardholders to transfer card  balances from one issuer to another, further increasing competition among  issuers. However, another study prepared by the Federal Reserve Board  also attributes declines in credit card interest rates to a sharp drop in  issuers’ cost of funds, which is the price issuers pay other lenders to obtain  the funds that are then lent to cardholders. (We discuss issuers’ cost of  funds later in this report.)
Our analysis of disclosures also found that the rates applicable to balance  transfers were generally the same as those assessed for purchases, but the  rates for cash advances were often higher. Of the popular cards offered by  the largest issuers, nearly all featured rates for balance transfers that were  substantially similar to their purchase rates, with many also offering low  introductory rates on balance transfers for about 8 months. However, the  rates these cards assessed for obtaining a cash advance were around 20  percent on average. Similarly to rates for purchases, the rates for cash  advances on most cards were also variable rates that would change  periodically with market interest rates.
section_title: Credit Cards Increasingly Have Assessed Higher Penalty Fees
paragraphs: Although featuring lower interest rates than in earlier decades, typical  cards today now include higher and more complex fees than they did in the  past for making late payments, exceeding credit limits, and processing  returned payments. One penalty fee, commonly included as part of credit  card terms, is the late fee, which issuers assess when they do not receive at  least the minimum required payment by the due date indicated in a  cardholder’s monthly billing statement. As noted earlier, prior to 1990, the  level of late fees on cards generally ranged from $5 to $10. However, late  fees have risen significantly. According to data reported by CardWeb.com,  Inc., credit card late fees rose from an average of $12.83 in 1995 to $33.64 in  2005, an increase of over 160 percent. Adjusted for inflation, these fees  increased about 115 percent on average, from $15.61 in 1995 to $33.64 in  2005. Similarly, Consumer Action, a consumer interest group that  conducts an annual survey of credit card costs, found late fees rose from an  average of $12.53 in 1995 to $27.46 in 2005, a 119 percent increase (or 80  percent after adjusting for inflation). Figure 4 shows trends in average  late fee assessments reported by these two groups.
In addition to increased fees a cardholder may be charged per occurrence,  many cards created tiered pricing that depends on the balance held by the  cardholder. Between 2003 and 2005, all but 4 of the 28 popular cards that  we analyzed used a tiered fee structure. Generally, these cards included  three tiers, with the following range of fees for each tier:   $15 to $19 on accounts with balances of $100 or $250;   $25 to $29 on accounts with balances up to about $1,000; and  $34 to $39 on accounts with balances of about $1,000 or more.
Tiered pricing can prevent issuers from assessing high fees to cardholders  with comparatively small balances. However, data from the Federal  Reserve’s Survey of Consumer Finances, which is conducted every 3 years,  show that the median total household outstanding balance on U.S. credit  cards was about $2,200 in 2004 among those that carried balances. When  we calculated the late fees that would be assessed on holders of the 28  cards if they had the entire median balance on one card, the average late  fee increased from $34 in 2003 to $37 in 2005, with 18 of the cards assessing  the highest fee of $39 in 2005.
Issuers also assess cardholders a penalty fee for exceeding the credit limit  set by the issuer. In general, issuers assess over-limit fees when a  cardholder exceeds the credit limit set by the card issuer. Similar to late  fees, over-limit fees also have been rising and increasingly involve a tiered  structure. According to data reported by CardWeb.com, Inc., the average  over-limit fees that issuers assessed increased 138 percent from $12.95 in  1995 to $30.81 in 2005. Adjusted for inflation, average over-limit fees  reported by CardWeb.com increased from $15.77 in 1995 to $30.81 in 2005,  representing about a 95 percent increase. Similarly, Consumer Action  found a 114 percent increase in this period (or 76 percent, after adjusting  for inflation). Figure 5 illustrates the trend in average over-limit fees over  the past 10 years from these two surveys.
The cards we analyzed also increasingly featured tiered structures for over- limit fees, with 29 percent (5 of 17 cards) having such structures in 2003,  and 53 percent (10 of 19 cards) in 2005. Most cards that featured tiered  over-limit fees assessed the highest fee on accounts with balances greater  than $1,000. But not all over-limit tiers were based on the amount of the  cardholder’s outstanding balance. Some cards based the amount of the  over-limit fee on other indicators, such as the amount of the cardholder’s  credit limit or card type. For the six largest issuers’ popular cards with  over-limit fees, the average fee that would be assessed on accounts that  carried the median U.S. household credit card balance of $2,200 rose from  $32 in 2003 to $34 in 2005. Among cards that assessed over-limit fees in  2005, most charged an amount between $35 and $39.
Not all of the 28 popular large-issuer cards included over-limit fees and the  prevalence of such fees may be declining. In 2003, 85 percent, or 17 of 20  cards, had such fees, but only 73 percent, or 19 of 26 cards, did in 2005.  According to issuer representatives, they are increasingly emphasizing  competitive strategies that seek to increase the amount of spending that  their existing cardholders do on their cards as a way to generate revenue.  This could explain a movement away from assessing over-limit fees, which  likely discourage cardholders who are near their credit limit from  spending.
Cards also varied in when an over-limit fee would be assessed. For  example, our analysis of the 28 popular large-issuer cards showed that, of  the 22 cards that assessed over-limit fees, about two-thirds (14 of 22) would  assess an over-limit fee if the cardholder’s balance exceeded the credit limit  within a billing cycle, whereas the other cards (8 of 22) would assess the  fee only if a cardholder’s balance exceeded the limit at the end of the billing  cycle. In addition, within the overall limit, some of the cards had separate  credit limits on the card for how much a cardholder could obtain in cash or  transfer from other cards or creditors, before similarly triggering an over- limit fee.
Finally, issuers typically assess fees on cardholders for submitting a  payment that is not honored by the issuer or the cardholder’s paying bank.  Returned payments can occur when cardholders submit a personal check  that is written for an amount greater than the amount in their checking  account or submit payments that cannot be processed. In our analysis of 28  popular cards offered by the six largest issuers, we found the average fee  charged for such returned payments remained steady between 2003 and  2005 at about $30.
section_title: Cards Now Frequently Include a Range of Other Fees
paragraphs: Since 1990, issuers have appended more fees to credit cards. In addition to  penalties for the cardholder actions discussed above, the 28 popular cards  now often include fees for other types of transactions or for providing  various services to cardholders. As shown in table 1, issuers assess fees for  such services as providing cash advances or for making a payment by  telephone. According to our analysis, not all of these fees were disclosed in  the materials that issuers generally provide to prospective or existing  cardholders. Instead, card issuers told us that they notified their customers  of these fees by other means, such as telephone conversations.
While issuers generally have been including more kinds of fees on credit  cards, one category has decreased: most cards offered by the largest  issuers do not require cardholders to pay an annual fee. An annual fee is a  fixed fee that issuers charge cardholders each year they continue to own  that card. Almost 75 percent of cards we reviewed charged no annual fee in  2005 (among those that did, the range was from $30 to $90). Also, an  industry group representative told us that approximately 2 percent of cards  featured annual fee requirements. Some types of cards we reviewed were  more likely to apply an annual fee than others. For example, cards that  offered airline tickets in exchange for points that accrue to a cardholder for  using the card were likely to apply an annual fee. However, among the 28  popular cards that we reviewed, not all of the cards that offered rewards  charged annual fees.
Recently, some issuers have introduced cards without certain penalty fees.  For example, one of the top six issuers has introduced a card that does not  charge a late fee, over-limit fee, cash-advance fee, returned payment fee, or  an annual fee. Another top-six issuer’s card does not charge the cardholder  a late fee as long as one purchase is made during the billing cycle. However,  the issuer of this card may impose higher interest rates, including above 30  percent, if the cardholder pays late or otherwise defaults on the terms of  the card.
section_title: Issuers Have Introduced Various Practices that Can Significantly Affect Cardholder Costs
paragraphs: Popular credit cards offered by the six largest issuers involve various issuer  practices that can significantly affect the costs of using a credit card for a  cardholder. These included practices such as raising a card’s interest rates  in response to cardholder behaviors and how payments are allocated  across balances.
subsections: section_title: Interest Rate Changes
paragraphs: One of the practices that can significantly increase the costs of using  typical credit cards is penalty pricing. Under this practice, the interest rate  applied to the balances on a card automatically can be increased in  response to behavior of the cardholder that appears to indicate that the  cardholder presents greater risk of loss to the issuer. For example,  representatives for one large issuer told us they automatically increase a  cardholder’s interest rate if a cardholder makes a late payment or exceeds  the credit limit. Card disclosure documents now typically include  information about default rates, which represent the maximum penalty rate  that issuers can assess in response to cardholders’ violations of the terms  of the card. According to an industry specialist at the Federal Reserve,  issuers first began the practice of assessing default interest rates as a  penalty for term violations in the late 1990s. As of 2005, all but one of the  cards we reviewed included default rates. The default rates were generally  much higher than rates that otherwise applied to purchases, cash advances,  or balance transfers. For example, the average default rate across the 28  cards was 27.3 percent in 2005—up from the average of 23.8 percent in  2003—with as many as 7 cards charging rates over 30 percent. Like many of  the other rates assessed on these cards in 2005, default rates generally were  variable rates. Increases in average default rates between 2003 and 2005  resulted from increases both in the prime rate, which rose about 2  percentage points during this time, and the average fixed amount that  issuers added. On average, the fixed amount that issuers added to the index  rate in setting default rate levels increased from about 19 percent in 2003 to  22 percent in 2005.
Four of the six largest issuers typically included conditions in their  disclosure documents that could allow the cardholder’s interest rate to be  reduced from a higher penalty rate. For example some issuers would lower  a cardholders’ rate for not paying late and otherwise abiding by the terms  of the card for a period of 6 or 12 consecutive months after the default rate  was imposed. However, at least one issuer indicated that higher penalty  rates would be charged on existing balances even after six months of good  behavior. This issuer assessed lower nonpenalty rates only on new  purchases or other new balances, while continuing to assess higher penalty  rates on the balance that existed when the cardholder was initially  assessed a higher penalty rate. This practice may significantly increase  costs to cardholders even after they’ve met the terms of their card  agreement for at least six months.
The specific conditions under which the largest issuers could raise a  cardholder’s rate to the default level on the popular cards that we analyzed  varied. The disclosures for 26 of the 27 cards that included default rates in  2005 stated that default rates could be assessed if the cardholders made  late payments. However, some cards would apply such default rates only  after multiple violations of card terms. For example, issuers of 9 of the  cards automatically would increase a cardholder’s rates in response to two  late payments. Additionally, for 18 of the 28 cards, default rates could apply  for exceeding the credit limit on the card, and 10 cards could also impose  such rates for returned payments. Disclosure documents for 26 of the 27  cards that included default rates also indicated that in response to these  violations of terms, the interest rate applicable to purchases could be  increased to the default rate. In addition, such violations would also cause  issuers to increase the rates applicable to cash advances on 16 of the cards,  as well as increase rates applicable to balance transfers on 24 of the cards.
According to a paper by a Federal Reserve Bank researcher, some issuers  began to increase cardholders’ interest rates in the early 2000s for actions  they took with other creditors. According to this paper, these issuers  would increase rates when cardholders failed to make timely payments to  other creditors, such as other credit card issuers, utility companies, and  mortgage lenders. Becoming generally known as “universal default,”  consumer groups criticized these practices. In 2004, OCC issued guidance  to the banks that it oversees, which include many of the largest card  issuers, which addressed such practices. While OCC noted that the  repricing might be an appropriate way for banks to manage their credit  risk, they also noted that such practices could heighten a bank’s  compliance and reputation risks. As a result, OCC urged national banks to  fully and prominently disclose in promotional materials the circumstances  under which a cardholder’s interest rates, fees, or other terms could be  changed and whether the bank reserved the right to change these  unilaterally. Around the time of this guidance, issuers generally ceased  automatically repricing cardholders to default interest rates for risky  behavior exhibited with other creditors. Of the 28 popular large issuer  cards that we reviewed, three cards in 2005 included terms that would  allow the issuer to automatically raise a cardholder’s rate to the default rate  if they made a late payment to another creditor.
Although the six largest U.S. issuers appear to have generally ceased  making automatic increases to a default rate for behavior with other  creditors, some continue to employ practices that allow them to seek to  raise a cardholder’s interest rates in response to behaviors with other  creditors. During our review, representatives of four of these issuers told us  that they may seek to impose higher rates on a cardholder in response to  behaviors related to other creditors but that such increases would be done  as a change-in-terms, which can require prior notification, rather than  automatically. Regulation Z requires that the affected cardholders be  notified in writing of any such proposed changes in rate terms at least 15  days before such change becomes effective. In addition, under the laws of  the states in which four of the six largest issuers are chartered, cardholders  would have to be given the right to opt out of the change. However, issuer  representatives told us that few cardholders exercise this right. The ability  of cardholders to opt out of such increases also has been questioned. For  example, one legal essay noted that some cardholders may not be able to  reject the changed terms of their cards if the result would be a requirement  to pay off the balance immediately. In addition, an association for  community banks that provided comments to the Federal Reserve as part  of the ongoing review of card disclosures noted that 15 days does not  provide consumers sufficient time to make other credit arrangements if the  new terms were undesirable.
section_title: Payment Allocation Method
paragraphs: The way that issuers allocate payments across balances also can increase  the costs of using the popular cards we reviewed. In this new credit  environment where different balances on a single account may be assessed  different interest rates, issuers have developed practices for allocating the  payments cardholders make to pay down their balance. For 23 of the 28  popular larger-issuer cards that we reviewed, cardholder payments would  be allocated first to the balance that is assessed the lowest rate of  interest. As a result, the low interest balance would have to be fully paid  before any of the cardholder’s payment would pay down balances assessed  higher rates of interest. This practice can prolong the length of time that  issuers collect finance charges on the balances assessed higher rates of  interest.
section_title: Balance Computation Method
paragraphs: Additionally, some of the cards we reviewed use a balance computation  method that can increase cardholder costs. On some cards, issuers have  used a double-cycle billing method, which eliminates the interest-free  period of a consumer who moves from nonrevolving to revolving status,  according to Federal Reserve staff. In other words, in cases where a  cardholder, with no previous balance, fails to pay the entire balance of new  purchases by the payment due date, issuers compute interest on the  original balance that previously had been subject to an interest-free period.  This method is illustrated in figure 6.
In our review of 28 popular cards from the six largest issuers, we found that  two of the six issuers used the double-cycle billing method on one or more  popular cards between 2003 and 2005. The other four issuers indicated they  would only go back one cycle to impose finance charges.
section_title: New Practices Appear to Affect a Minority of Cardholders
paragraphs: Representatives of issuers, consumer groups, and others we interviewed  generally disagreed over whether the evolution of credit card pricing and  other practices has been beneficial to consumers. However, data provided  by the six largest issuers show that many of their active accounts did not  pay finance charges and that a minority of their cardholders were affected  by penalty charges in 2005.
subsections: section_title: Issuers Say Practices Benefit More Cardholders, but Critics Say Some Practices Harm Consumers
paragraphs: The movement towards risk-based pricing for cards has allowed issuers to  offer better terms to some cardholders and more credit cards to others.  Spurred by increased competition, many issuers have adopted risk-based  pricing structures in which they assess different rates on cards depending  on the credit quality of the borrower. Under this pricing structure, issuers  have offered cards with lower rates to more creditworthy borrowers, but  also have offered credit to consumers who previously would not have been  considered sufficiently creditworthy. For example, about 70 percent of  families held a credit card in 1989, but almost 75 percent held a card by  2004, according to the Federal Reserve Board’s Survey of Consumer  Finances. Cards for these less creditworthy consumers have featured  higher rates to reflect the higher repayment risk that such consumers  represented. For example, the initial purchase rates on the 28 popular  cards offered by the six largest issuers ranged from about 8 percent to 19  percent in 2005.
According to card issuers, credit cards offer many more benefits to users  than they did in the past. For example, according to the six largest issuers,  credit cards are an increasingly convenient and secure form of payment.  These issuers told us credit cards are accepted at more than 23 million  merchants worldwide, can be used to make purchases or obtain cash, and  are the predominant form of payment for purchases made on the Internet.  They also told us that rewards, such as cash-back and airline travel, as well  as other benefits, such as rental car insurance or lost luggage protection,  also have become standard. Issuers additionally noted that credit cards are  reducing the need for cash. Finally, they noted that cardholders typically  are not responsible for loss, theft, fraud, or misuse of their credit cards by  unauthorized users, and issuers often assist cardholders that are victims of  identity theft.
In contrast, according to some consumer groups and others, the newer  pricing structures have resulted in many negative outcomes for some  consumers. Some consumer advocates noted adverse consequences of  offering credit, especially at higher interest rates, to less creditworthy  consumers. For example, lower-income or young consumers, who do not  have the financial means to carry credit card debt, could worsen their  financial condition. In addition, consumer groups and academics said that  various penalty fees could increase significantly the costs of using cards for  some consumers. Some also argued that card issuers were overly  aggressive in their assessment of penalty fees. For instance, a  representative of a consumer group noted that issuers do not reject  cardholders’ purchases during the sale authorization, even if the  transaction would put the cardholder over the card’s credit limit, and yet  will likely later assess that cardholder an over-limit fee and also may  penalize them with a higher interest rate. Furthermore, staff for one  banking regulator told us that they have received complaints from  consumers who were assessed over-limit fees that resulted from the  balance on their accounts going over their credit limit because their card  issuer assessed them a late fee. At the same time, credit card issuers have  incentives not to be overly aggressive with their assessment of penalty  charges. For example, Federal Reserve representatives told us that major  card issuers with long-term franchise value are concerned that their banks  not be perceived as engaging in predatory lending because this could pose  a serious risk to their brand reputation. As a result, they explained that  issuers may be wary of charging fees that could be considered excessive or  imposing interest rates that might be viewed as potentially abusive. In  contrast, these officials noted that some issuers, such as those that focus  on lending to consumers with lower credit quality, may be less concerned  about their firm’s reputation and, therefore, more likely to charge higher  fees.
Controversy also surrounds whether higher fees and other charges were  commensurate with the risks that issuers faced. Consumer groups and  others questioned whether the penalty interest rates and fees were  justifiable. For example, one consumer group questioned whether  submitting a credit card payment one day late made a cardholder so risky  that it justified doubling or tripling the interest rate assessed on that  account. Also, as the result of concerns over the level of penalty fees being  assessed by banks in the United Kingdom, a regulator there has recently  announced that penalty fees greater than 12 pounds (about $23) may be  challenged as unfair unless they can be justified by exceptional factors.  Representatives of several of the issuers with whom we spoke told us that  the levels of the penalty fees they assess generally were set by considering  various factors. For example, they noted that higher fees help to offset the  increased risk of loss posed by cardholders who pay late or engage in other  negative behaviors. Additionally, they noted a 2006 study, which compared  the assessment of penalty fees that credit card banks charged to  bankruptcy rates in the states in which their cards were marketed, and  found that late fee assessments were correlated with bankruptcy rates.  Some also noted that increased fee levels reflected increased operating  costs; for example, not receiving payments when due can cause the issuer  to incur increased costs, such as those incurred by having to call  cardholders to request payment. Representatives for four of the largest  issuers also told us that their fee levels were influenced by what others in  the marketplace were charging.
Concerns also have been expressed about whether consumers adequately  consider the potential effect of penalty interest rates and fees when they  use their cards. For example, one academic researcher, who has written  several papers about the credit card industry, told us that many consumers  do not consider the effect of the costs that can accrue to them after they  begin using a credit card. According to this researcher, many consumers  focus primarily on the amount of the interest rate for purchases when  deciding to obtain a new credit card and give less consideration to the level  of penalty charges and rates that could apply if they were to miss a  payment or violate some other term of their card agreement. An analyst  that studies the credit card industry for large investors said that consumers  can obtain low introductory rates but can lose them very easily before the  introductory period expires.
section_title: Most Active Accounts Are Assessed Lower Rates Than in the Past
paragraphs: As noted previously, the average credit card interest rate assessed for  purchases has declined from almost 20 percent, that prevailed until the late  1980s, to around 12 percent, as of 2005. In addition, the six largest issuers— whose accounts represent 61 percent of all U.S. accounts—reported to us  that the majority of their cardholders in 2005 had cards with interest rates  lower than the rate that generally applied to all cardholders prior to about  1990. According to these issuers, about 80 percent of active accounts were  assessed interest rates below 20 percent as of December 31, 2005, with  more than 40 percent having rates below 15 percent. However, the  proportion of active accounts assessed rates below 15 percent declined  since 2003, when 71 percent received such rates. According to issuer  representatives, a greater number of active accounts were assessed higher  interest rates in 2004 and 2005 primarily because of changes in the prime  rate to which many cards’ variable rates are indexed. Nevertheless,  cardholders today have much greater access to cards with lower interest  rates than existed when all cards charged a single fixed rate.
A large number of cardholders appear to avoid paying any significant  interest charges. Many cardholders do not revolve a balance from month to  month, but instead pay off the balance owed in full at the end of each  month. Such cardholders are often referred to as convenience users.  According to one estimate, about 42 percent of cardholders are  convenience users. As a result, many of these cardholders availed  themselves of the benefits of their cards without incurring any direct  expenses. Similarly, the six largest issuers reported to us that almost half,  or 48 percent, of their active accounts did not pay a finance charge in at  least 10 months in 2005, similar to the 47 percent that did so in 2003 and  2004.
section_title: Minority of Cardholders Appear to Be Affected by Penalty Charges Assessed by the Largest U.S. Issuers
paragraphs: Penalty interest rates and fees appear to affect a minority of the largest six  issuers’ cardholders. No comprehensive sources existed to show the  extent to which U.S. cardholders were paying penalty interest rates, but,  according to data provided by the six largest issuers, a small proportion of  their active accounts were being assessed interest rates above 25 percent— which we determined were likely to represent penalty rates. However, this  proportion had more than doubled over a two-year period by having  increased from 5 percent at the end of 2003 to 10 percent in 2004 and 11  percent in 2005.
Although still representing a minority of cardholders, cardholders paying at  least one type of penalty fee were a significant proportion of all  cardholders. According to the six largest issuers, 35 percent of their active  accounts had been assessed at least one late fee in 2005. These issuers  reported that their late fee assessments averaged $30.92 per active account.  Additionally, these issuers reported that they assessed over-limit fees on 13  percent of active accounts in 2005, with an average over-limit fee of $9.49  per active account.
section_title: Weaknesses in Credit Card Disclosures Appear to Hinder Cardholder Understanding of Fees and Other Practices That Can Affect Their Costs
paragraphs: The disclosures that issuers representing the majority of credit card  accounts use to provide information about the costs and terms of using  credit cards had serious weaknesses that likely reduce their usefulness to  consumers. These disclosures are the primary means under federal law for  protecting consumers against inaccurate and unfair credit card practices.  The disclosures we analyzed had weaknesses, such as presenting  information written at a level too difficult for the average consumer to  understand, and design features, such as text placement and font sizes, that  did not conform to guidance for creating easily readable documents. When  attempting to use these disclosures, cardholders were often unable to  identify key rates or terms and often failed to understand the information in  these documents. Several factors help explain these weaknesses, including  outdated regulations and guidance. With the intention of improving the  information that consumers receive, the Federal Reserve has initiated a  comprehensive review of the regulations that govern credit card  disclosures. Various suggestions have been made to improve disclosures,  including testing them with consumers. While Federal Reserve staff have  begun to involve consumers in their efforts, they are still attempting to  determine the best form and content of any revised disclosures. Without  clear, understandable information, consumers risk making poor choices  about using credit cards, which could unnecessarily result in higher costs  to use them.
subsections: section_title: Mandatory Disclosure of Credit Card Terms and Conditions Is the Primary Means Regulators Use for Ensuring Competitive Credit Card Pricing
paragraphs: Having adequately informed consumers that spur competition among  issuers is the primary way that credit card pricing is regulated in the United  States. Under federal law, a national bank may charge interest on any loan  at a rate permitted by the law of the state in which the bank is located. In  1978, the U.S. Supreme Court ruled that a national bank is “located” in the  state in which it is chartered, and, therefore, the amount of the interest  rates charged by a national bank are subject only to the laws of the state in  which it is chartered, even if its lending activities occur elsewhere. As a  result, the largest credit card issuing banks are chartered in states that  either lacked interest rate caps or had very high caps from which they  would offer credit cards to customers in other states. This ability to  “export” their chartered states’ interest rates effectively removed any caps  applicable to interest rates on the cards from these banks. In 1996, the U.S.  Supreme Court determined that fees charged on credit extended by  national banks are a form of interest, allowing issuers to also export the  level of fees allowable in their state of charter to their customers  nationwide, which effectively removed any caps on the level of fees that  these banks could charge.
In the absence of federal regulatory limitations on the rates and fees that  card issuers can assess, the primary means that U.S. banking regulators  have for influencing the level of such charges is by facilitating competition  among issuers, which, in turn, is highly dependent on informed consumers.  The Truth in Lending Act of 1968 (TILA) mandates certain disclosures  aimed at informing consumers about the cost of credit. In approving TILA,  Congress intended that the required disclosures would foster price  competition among card issuers by enabling consumers to discern  differences among cards while shopping for credit. TILA also states that its  purpose is to assure that the consumer will be able to compare more  readily the various credit terms available to him or her and avoid the  uninformed use of credit. As authorized under TILA, the Federal Reserve  has promulgated Regulation Z to carry out the purposes of TILA. The  Federal Reserve, along with the other federal banking agencies, enforces  compliance with Regulation Z with respect to the depository institutions  under their respective supervision.
In general, TILA and the accompanying provisions of Regulation Z require  credit card issuers to inform potential and existing customers about  specific pricing terms at specific times. For example, card issuers are  required to make various disclosures when soliciting potential customers,  as well as on the actual applications for credit. On or with card applications  and solicitations, issuers generally are required to present pricing terms,  including the interest rates and various fees that apply to a card, as well as  information about how finance charges are calculated, among other things.  Issuers also are required to provide cardholders with specified disclosures  prior to the cardholder’s first transaction, periodically in billing statements,  upon changes to terms and conditions pertaining to the account, and upon  account renewal. For example, in periodic statements, which issuers  typically provide monthly to active cardholders, issuers are required to  provide detailed information about the transactions on the account during  the billing cycle, including purchases and payments, and are to disclose the  amount of finance charges that accrued on the cardholder’s outstanding  balance and detail the type and amount of fees assessed on the account,  among other things.
In addition to the required timing and content of disclosures, issuers also  must adhere to various formatting requirements. For example, since 1989,  certain pricing terms must be disclosed in direct mail, telephone, and other  applications and solicitations and presented in a tabular format on mailed  applications or solicitations. This table, generally referred to as the  Schumer box, must contain information about the interest rates and fees  that could be assessed to the cardholder, as well as information about how  finance charges are calculated, among other things. According to a  Federal Reserve representative, the Schumer box is designed to be easy for  consumers to read and use for comparing credit cards. According to a  consumer group representative, an effective regulatory disclosure is one  that stimulates competition among issuers; the introduction of the  Schumer box in the late 1980s preceded the increased price competition in  the credit card market in the early 1990s and the movement away from  uniform credit card products.
Not all fees that are charged by card issuers must be disclosed in the  Schumer box. Regulation Z does not require that issuers disclose fees  unrelated to the opening of an account. For example, according to the  Official Staff Interpretations of Regulation Z (staff interpretations),  nonperiodic fees, such as fees charged for reproducing billing statements  or reissuing a lost or stolen card, are not required to be disclosed. Staff  interpretations, which are compiled and published in a supplement to  Regulation Z, are a means of guiding issuers on the requirements of  Regulation Z. Staff interpretations also explain that various fees are not  required in initial disclosure statements, such as a fee to expedite the  delivery of a credit card or, under certain circumstances, a fee for arranging  a single payment by telephone. However, issuers we surveyed told us they  inform cardholders about these other fees at the time the cardholders  request the service, rather than in a disclosure document.
Although Congress authorized solely the Federal Reserve to adopt  regulations to implement the purposes of TILA, other federal banking  regulators, under their authority to ensure the safety and soundness of  depository institutions, have undertaken initiatives to improve the credit  card disclosures made by the institutions under their supervision. For  example, the regulator of national banks, OCC, issued an advisory letter in  2004 alerting banks of its concerns regarding certain credit card marketing  and account management practices that may expose a bank to compliance  and reputation risks. One such practice involved the marketing of  promotional interest rates and conditions under which issuers reprice  accounts to higher interest rates. In its advisory letter, OCC recommended  that issuers disclose any limits on the applicability of promotional interest  rates, such as the duration of the rates and the circumstances that could  shorten the promotional rate period or cause rates to increase.  Additionally, OCC advised issuers to disclose the circumstances under  which they could increase a consumer’s interest rate or fees, such as for  failure to make timely payments to another creditor.
section_title: Credit Card Disclosures Typically Provided to Many Consumers Have Various Weaknesses
paragraphs: The disclosures that credit card issuers typically provide to potential and  new cardholders had various weaknesses that reduced their usefulness to  consumers. These weaknesses affecting the disclosure materials included  the typical grade level required to comprehend them, their poor  organization and formatting of information, and their excessive detail and  length.
subsections: section_title: Disclosures Written at Too High a Level
paragraphs: The typical credit card disclosure documents contained content that was  written at a level above that likely to be understandable by many  consumers. To assess the readability of typical credit card disclosures, we  contracted with a private usability consultant to evaluate the two primary  disclosure documents for four popular, widely-held cards (one each from  four large credit card issuers). The two documents were (1) a direct mail  solicitation letter and application, which must include information about  the costs and fees associated with the card; and (2) the cardmember  agreement that contains the full range of terms and conditions applicable  to the card. Through visual inspection, we determined that this set of  disclosures appeared representative of the disclosures for the 28 cards we  reviewed from the six largest issuers that accounted for the majority of  cardholders in the United States. To determine the level of education likely  needed for someone to understand these disclosures, the usability  consultant used computer software programs that applied three widely  used readability formulas to the entire text of the disclosures. These  formulas determined the readability of written material based on  quantitative measures, such as average number of syllables in words or  numbers of words in sentences. For more information about the usability  consultant’s analyses, see appendix I.
On the basis of the usability consultant’s analysis, the disclosure  documents provided to many cardholders likely were written at a level too  high for the average individual to understand. The consultant found that  the disclosures on average were written at a reading level commensurate  with about a tenth- to twelfth-grade education. According to the  consultant’s analysis, understanding the disclosures in the solicitation  letters would require an eleventh-grade level of reading comprehension,  while understanding the cardmember agreements would require about a  twelfth-grade education. A consumer advocacy group that tested the  reading level needed to understand credit card disclosures arrived at a  similar conclusion. In a comment letter to the Federal Reserve, this  consumer group noted it had measured a typical passage from a change-in- terms notice on how issuers calculate finance charges using one of the  readability formulas and that this passage required a twelfth-grade reading  level.
These disclosure documents were written such that understanding them  required a higher reading level than that attained by many U.S. cardholders.  For example, a nationwide assessment of the reading level of the U.S.  population cited by the usability consultant indicated that nearly half of the  adult population in the United States reads at or below the eighth-grade  level. Similarly, to ensure that the information that public companies are  required to disclose to prospective investors is adequately understandable,  the Securities and Exchange Commission (SEC) recommends that such  disclosure materials be written at a sixth- to eighth-grade level.
In addition to the average reading level, certain portions of the typical  disclosure documents provided by the large issuers required even higher  reading levels to be understandable. For example, the information that  appeared in cardmember agreements about annual percentage rates, grace  periods, balance computation, and payment allocation methods required a  minimum of a fifteenth-grade education, which is the equivalent of 3 years  of college education. Similarly, text in the documents describing the  interest rates applicable to one issuer’s card were written at a twenty- seventh-grade level. However, not all text in the disclosures required such  high levels. For example, the consultant found that the information about  fees that generally appeared in solicitation letters required only a seventh-  and eighth-grade reading level to be understandable. Solicitation letters  likely required lower reading levels to be understandable because they  generally included more information in a tabular format than cardmember  agreements.
section_title: Poor Organization and Formatting
paragraphs: The disclosure documents the consultant evaluated did not use designs,  including effective organizational structures and formatting, that would  have made them more useful to consumers. To assess the adequacy of the  design of the typical large issuer credit card solicitation letters and  cardmember agreements, the consultant evaluated the extent to which  these disclosures adhered to generally accepted industry standards for  effective organizational structures and designs intended to make  documents easy to read. In the absence of best practices and guidelines  specifically for credit card disclosures, the consultant used knowledge of  plain language, publications design guidelines, and industry best practices  and also compared the credit card disclosure documents to the guidelines  in the Securities and Exchange Commission’s plain English handbook. The  usability consultant used these standards to identify aspects of the design  of the typical card disclosure documents that could cause consumers using  them to encounter problems.
On the basis of this analysis, the usability consultant concluded that the  typical credit card disclosures lacked effective organization. For example,  the disclosure documents frequently placed pertinent information toward  the end of sentences. Figure 7 illustrates an example taken from the  cardmember agreement of one of the large issuers that shows that a  consumer would need to read through considerable amounts of text before  reaching the important information, in this case the amount of the annual  percentage rate (APR) for purchases. Best practices would dictate that  important information—the amount of the APR—be presented first, with  the less important information—the explanation of how the APR is  determined—placed last.
In addition, the disclosure documents often failed to group relevant  information together. Although one of the disclosure formats mandated by  law—the Schumer box—has been praised as having simplified the  presentation of complex information, our consultant observed that the  amount of information that issuers typically presented in the box  compromised the benefits of using a tabular format. Specifically, the typical  credit card solicitation letter, which includes a Schumer box, may be  causing difficulties for consumers because related information generally is  not grouped appropriately, as shown in figure 8.
As shown in figure 8, information about the APR that would apply to  purchases made with the card appeared in three different locations. The  first row includes the current prevailing rate of the purchase APR; text that  describes how the level of the purchase APR could vary according to an  underlying rate, such as the prime rate, is included in the third row; and  text describing how the issuer determines the level of this underlying rate  is included in the footnotes. According to the consultant, grouping such  related information together likely would help readers to more easily  understand the material.
In addition, of the four issuers whose materials were analyzed, three  provided a single document with all relevant information in a single  cardmember agreement, but one issuer provided the information in  separate documents. For example, this issuer disclosed specific  information about the actual amount of rates and fees in one document and  presented information about how such rates were determined in another  document. According to the readability consultant, disclosures in multiple  documents can be more difficult for the reader to use because they may  require more work to find information.
Formatting weaknesses also likely reduced the usefulness of typical credit  card disclosure documents. The specific formatting issues were as follows:   Font sizes. According to the usability consultant’s analysis, many of the  disclosure documents used font sizes that were difficult to read and  could hinder consumers’ ability to find information. For example, the  consultant found extensive use of small and condensed typeface in  cardmember agreements and in footnotes in solicitation materials when  best practices would suggest using a larger, more legible font size.  Figure 9 contains an illustration of how the disclosures used condensed  text that makes the font appear smaller than it actually is. Multiple  consumers and consumer groups who provided comments to the  Federal Reserve noted that credit card disclosures were written in a  small print that reduces a consumer’s ability to read or understand the  document. For example, a consumer who provided comments to the  Federal Reserve referred to the text in card disclosures as “mice type.”  This example also illustrates how notes to the text, which should be less  important, were the same size and thus given the same visual emphasis  as the text inside the box. Consumers attempting to read such  disclosures may have difficulty determining which information is more  important.
Ineffective font placements. According to the usability consultant, some  issuers’ efforts to distinguish text using different font types sometimes  had the opposite effect. The consultant found that the disclosures from  all four issuers emphasized large amounts of text with all capital letters  and sometimes boldface. According to the consultant, formatting large  blocks of text in capitals makes it harder to read because the shapes of  the words disappear, forcing the reader to slow down and study each  letter (see figure 10). In a comment letter to the Federal Reserve, an  industry group recommended that boldfaced or capitalized text should  be used discriminately, because in its experience, excessive use of such  font types caused disclosures to lose all effectiveness. SEC’s guidelines  for producing clear disclosures contain similar suggestions.
Selecting text for emphasis. According to the usability consultant, most  of the disclosure documents unnecessarily emphasized specific terms.  Inappropriate emphasis of such material could distract readers from  more important messages. Figure 11 contains a passage from one  cardmember agreement that the readability consultant singled out for  its emphasis of the term “periodic finance charge,” which is repeated six  times in this example. According to the consultant, the use of boldface  and capitalized text calls attention to the word, potentially requiring  readers to work harder to understand the entire passage’s message.
Use of headings. According to the usability consultant, disclosure  documents from three of the four issuers analyzed contained  headings that were difficult to distinguish from surrounding text.  Headings, according to the consultant, provide a visual hierarchy to  help readers quickly identify information in a lengthy document.  Good headers are easy to identify and use meaningful labels. Figure  12 illustrates two examples of how the credit card disclosure  documents failed to use headings effectively.
In the first example, the headings contained an unnecessary string of  numbers that the consultant found would make locating a specific topic in  the text more difficult. As a result, readers would need to actively ignore  the string of numbers until the middle of the line to find what they wanted.  The consultant noted that such numbers might be useful if this document  had a table of contents that referred to the numbers, but it did not. In the  second example, the consultant noted that a reader’s ability to locate  information using the headings in this document was hindered because the  headings were not made more visually distinct, but instead were aligned  with other text and printed in the same type size as the text that followed.  As a result, these headings blended in with the text. Furthermore, the  consultant noted that because the term “Annual Percentage Rates” was  given the same visual treatment as the two headings in the example, finding  headings quickly was made even more difficult. In contrast, figure 12 also  shows an example that the consultant identified in one of the disclosure  documents that was an effective use of headings.
Presentation techniques. According to the usability consultant, the  disclosure documents analyzed did not use presentation techniques,  such as tables, bulleted lists, and graphics, that could help to simplify  the presentation of complicated concepts, especially in the cardmember  agreements. Best practices for document design suggest using tables  and bulleted lists to simplify the presentation of complex information.  Instead, the usability consultant noted that all the cardmember  agreements reviewed almost exclusively employed undifferentiated  blocks of text, potentially hindering clear communication of complex  information, such as the multiple-step procedures issuers use for  calculating a cardholder’s minimum required payment. Figure 13 below  presents two samples of text from different cardmember agreements  describing how minimum payments are calculated. According to the  consultant, the sample that used a bulleted list was easier to read than  the one formatted as a paragraph. Also, an issuer stated in a letter to the  Federal Reserve that their consumers have welcomed the issuer’s use of  bullets to format information, emphasizing the concept that the visual  layout of information either facilitates or hinders consumer  understanding.
The content of typical credit card disclosure documents generally was  overly complex and presented in too much detail, such as by using  unfamiliar or complex terms to describe simple concepts. For example, the  usability consultant identified one cardmember agreement that used the  term “rolling consecutive twelve billing cycle period” instead of saying  “over the course of the next 12 billing statements” or “next 12 months”—if  that was appropriate. Further, a number of consumers, consumer advocacy  groups, and government and private entities that have provided comments  to the Federal Reserve agreed that typical credit card disclosures are  written in complex language that hinders consumers’ understanding. For  example, a consumer wrote that disclosure documents were “loaded with  booby traps designed to trip consumers, and written in intentionally  impenetrable and confusing language.” One of the consumer advocacy  groups stated the disclosures were “full of dense, impenetrable legal jargon  that even lawyers and seasoned consumer advocates have difficulty  understanding.” In addition, the consultant noted that many of the  disclosures, including solicitation letters and cardmember agreements,  contained overly long and complex sentences that increase the effort a  reader must devote to understanding the text. Figure 14 contains two  examples of instances in which the disclosure documents used uncommon  words and phrases to express simple concepts.
In addition, the disclosure documents regularly presented too much or  irrelevant detail. According to the usability consultant’s analysis, the credit  card disclosures often contained superfluous information. For example,  figure 15 presents an example of text from one cardmember agreement that  described the actions the issuer would take if its normal source for the rate  information used to set its variable rates—The Wall Street Journal—were  to cease publication. Including such an arguably unimportant detail  lengthens and makes this disclosure more complex. According to SEC best  practices for creating clear disclosures, disclosure documents are more  effective when they adhere to the rule that less is more. By omitting  unnecessary details from disclosure documents, the usability consultant  indicated that consumers would be more likely to read and understand the  information they contain.
section_title: Consumer Confusion Indicated That Disclosures Were Not Communicating Credit Card Cost Information Clearly
paragraphs: Many of the credit cardholders that were tested and interviewed as part of  our review exhibited confusion over various fees, practices, and other  terms that could affect the cost of using their credit cards. To understand  how well consumers could use typical credit card disclosure documents to  locate and understand information about card fees and other practices, the  usability consultant with whom we contracted used a sample of  cardholders to perform a usability assessment of the disclosure documents  from the four large issuers. As part of this assessment, the consultant  conducted one-on-one sessions with a total of 12 cardholders so that each  set of disclosures, which included a solicitation letter and a cardmember  agreement, was reviewed by 3 cardholders. Each of these cardholders  were asked to locate information about fee levels and rates, the  circumstances in which they would be imposed, and information about  changes in card terms. The consultant also tested the cardholders’ ability to  explain various practices used by the issuer, such as the process for  determining the amount of the minimum monthly payment, by reading the  disclosure documents. Although the results of the usability testing cannot  be used to make generalizations about all cardholders, the consultant  selected cardholders based on the demographics of the U.S. adult  population, according to age, education level, and income, to ensure that  the cardholders tested were representative of the general population. In  addition, as part of this review, we conducted one-on-one interviews with  112 cardholders to learn about consumer behavior and knowledge about  various credit card terms and practices. Although we also selected these  cardholders to reflect the demographics of the U.S. adult population, with  respect to age, education level, and income, the results of these interviews  cannot be generalized to the population of all U.S. cardholders.
Based on the work with consumers, specific aspects of credit card terms  that apparently were not well understood included:   Default interest rates. Although issuers can penalize cardholders for  violating the terms of the card, such as by making late payments or by  increasing the interest rates in effect on the cardholder’s account to  rates as high as 30 percent or more, only about half of the cardholders  that the usability consultant tested were able to use the typical credit  card disclosure documents to successfully identify the default rate and  the circumstances that would trigger rate increases for these cards. In  addition, the usability consultant observed the cardholders could not  identify this information easily. Many also were unsure of their answers,  especially when rates were expressed as a “prime plus” number,  indicating the rate varied based on the prime rate. Locating information  in the typical cardmember agreement was especially difficult for  cardholders, as only 3 of 12 cardholders were able to use such  documents to identify the default interest rate applicable to the card.  More importantly, only about half of the cardholders tested using  solicitation letters were able to accurately determine what actions could  potentially cause the default rate to be imposed on these cards.
Other penalty rate increases. Although card issuers generally reserve  the right to seek to raise a cardholder’s rate in other situations, such as  when a cardholder makes a late payment to another issuer’s credit card,  (even if the cardholder has not defaulted on the cardmember  agreement), about 71 percent of the 112 cardholders we interviewed  were unsure or did not believe that issuers could increase their rates in  such a case. In addition, about two-thirds of cardholders we interviewed  were unaware or did not believe that a drop in their credit score could  cause an issuer to seek to assess higher interest rates on their account.
Late payment fees. According to the usability assessment, many of the  cardholders had trouble using the disclosure documents to correctly  identify what would occur if a payment were to be received after the due  date printed in the billing statement. For example, nearly half of the  cardholders were unable to use the cardmember agreement to  determine whether a payment would be considered late based on the  date the issuer receives the payment or the date the payment was mailed  or postmarked. Additionally, the majority of the 112 cardholders we  interviewed also exhibited confusion over late fees: 52 percent indicated  that they have been surprised when their card company applied a fee or  penalty to their account.
Using a credit card to obtain cash. Although the cardholders tested by  the consultant generally were able to use the disclosures to identify how  a transaction fee for a cash advance would be calculated, most were  unable to accurately use this information to determine the transaction  fee for withdrawing funds, usually because they neglected to consider  the minimum dollar amount, such as $5 or $10, that would be assessed.
Grace periods. Almost all 12 cardholders in the usability assessment  had trouble using the solicitation letters to locate and define the grace  period, the period during which the a cardholder is not charged interest  on a balance. Instead, many cardholders incorrectly indicated that the  grace period was instead when their lower, promotional interest rates  would expire. Others incorrectly indicated that it was the amount of  time after the monthly bill’s due date that a cardholder could submit a  payment without being charged a late fee.
Balance computation method. Issuers use various methods to calculate  interest charges on outstanding balances, but only 1 of the 12  cardholders the usability consultant tested correctly described average  daily balance, and none of the cardholders were able to describe two- cycle average daily balance accurately. At least nine letters submitted to  the Federal Reserve in connection with its review of credit card  disclosures noted that few consumers understand balance computation  methods as stated in disclosure documents.
Perhaps as a result of weaknesses previously described, cardholders  generally avoid using the documents issuers provide with a new card to  improve their understanding of fees and practices. For example, many of  the cardholders interviewed as part of this report noted that the length,  format, and complexity of disclosures led them to generally disregard the  information contained in them. More than half (54 percent) of the 112  cardholders we interviewed indicated they read the disclosures provided  with a new card either not very closely or not at all. Instead, many  cardholders said they would call the issuer’s customer service  representatives for information about their card’s terms and conditions.  Cardholders also noted that the ability of issuers to change the terms and  conditions of a card at any time led them to generally disregard the  information contained in card disclosures. Regulation Z allows card issuers  to change the terms of credit cards provided that issuers notify cardholders  in writing within 15 days of the change. As a result, the usability consultant  observed some participants were dismissive of the information in the  disclosure documents because they were aware that issuers could change  anything.
section_title: Federal Reserve Effort to Revise Regulations Presents Opportunity to Improve Disclosures
paragraphs: With liability concerns and outdated regulatory requirements seemingly  explaining the weaknesses in card disclosures, the Federal Reserve has  begun efforts to review its requirements for credit card disclosures.  Industry participants have advocated various ways in which the Federal  Reserve can act to improve these disclosures and otherwise assist  cardholders.
subsections: section_title: Regulations and Guidance May Contribute to Weaknesses in Current Disclosures
paragraphs: Several factors may help explain why typical credit card disclosures exhibit  weaknesses that reduce their usefulness to cardholders. First, issuers make  decisions about the content and format of their disclosures to limit  potential legal liability. Issuer representatives told us that the disclosures  made in credit card solicitations and cardmember agreements are written  for legal purposes and in language that consumers generally could not  understand. For example, representatives for one large issuer told us they  cannot always state information in disclosures clearly because the  increased potential that simpler statements would be misinterpreted would  expose them to litigation. Similarly, a participant of a symposium on credit  card disclosures said that disclosures typically became lengthier after the  issuance of court rulings on consumer credit issues. Issuers can attempt to  reduce the risk of civil liability based on their disclosures by closely  following the formats that the Federal Reserve has provided in its model  forms and other guidance. According to the regulations that govern card  disclosures, issuers acting in good faith compliance with any interpretation  issued by a duly authorized official or employee of the Federal Reserve are  afforded protection from liability.
Second, the regulations governing credit card disclosures have become  outdated. As noted earlier in this report, TILA and Regulation Z that  implements the act’s provisions are intended to ensure that consumers  have adequate information about potential costs and other applicable  terms and conditions to make appropriate choices among competing credit  cards. The most recent comprehensive revisions to Regulation Z’s open-end  credit rules occurred in 1989 to implement the provisions of the Fair Credit  and Charge Card Act. As we have found, the features and cost structures of  credit cards have changed considerably since then. An issuer  representative told us that current Schumer box requirements are not as  useful in presenting the more complicated structures of many current  cards. For example, they noted that it does not easily accommodate  information about the various cardholder actions that could trigger rate  increases, which they argued is now important information for consumers  to know when shopping for credit. As a result, some of the specific  requirements of Regulation Z that are intended to ensure that consumers  have accurate information instead may be diminishing the usefulness of  these disclosures.
Third, the guidance that the Federal Reserve provides issuers may not be  consistent with guidelines for producing clear, written documents. Based  on our analysis, many issuers appear to adhere to the formats and model  forms that the Federal Reserve staff included in the Official Staff  Interpretations of Regulation Z, which are prepared to help issuers comply  with the regulations. For example, the model forms present text about how  rates are determined in footnotes. However, as discussed previously, not  grouping related information undermines the usability of documents. The  Schumer box format requires a cardholder to look in several places, such  as in multiple rows in the table and in notes to the table, for information  about related aspects of the card. Similarly, the Federal Reserve’s model  form for the Schumer box recommends that the information about the  transaction fee and interest rate for cash advances be disclosed in different  areas.
Finally, the way that issuers have implemented regulatory guidance may  have contributed to the weaknesses typical disclosure materials exhibited.  For example, in certain required disclosures, the terms “annual percentage  rate” and “finance charge,” when used with a corresponding amount or  percentage rate, are required to be more conspicuous than any other  required disclosures. Staff guidance suggests that such terms may be  made more conspicuous by, for example, capitalizing these terms when  other disclosures are printed in lower case or by displaying these terms in  larger type relative to other disclosures, putting them in boldface print or  underlining them. Our usability consultant’s analysis found that card  disclosure documents that followed this guidance were less effective  because they placed an inappropriate emphasis on terms. As shown  previously in figure 11, the use of bold and capital letters to emphasize the  term “finance charge” in the paragraph unnecessarily calls attention to that  term, potentially distracting readers from information that is more  important. The excerpt shown in figure 11 is from an initial disclosure  document which, according to Regulation Z, is subject to the “more  conspicuous” rule requiring emphasis of the terms “finance charge” and  “annual percentage rate.”
section_title: Suggestions for Improving Disclosures Included Obtaining Input from Consumers
paragraphs: With the intention of improving credit card disclosures, the Federal  Reserve has begun efforts to develop new regulations. According to its  2004 notice seeking public comments on Regulation Z, the Federal Reserve  hopes to address the length, complexity, and superfluous information of  disclosures and produce new disclosures that will be more useful in  helping consumers compare credit products. After the passage of the  Bankruptcy Abuse Prevention and Consumer Protection Act of 2005  (Bankruptcy Act) in October of that year, which included amendments to  TILA, the Federal Reserve sought additional comments from the public to  prepare to implement new disclosure requirements including disclosures  intended to advise consumers of the consequences of making only  minimum payments on credit cards. According to Federal Reserve staff,  new credit card disclosure regulations may not be in effect until sometime  in 2007 or 2008 because of the time required to conduct consumer testing,  modify the existing regulations, and then seek comment on the revised  regulation.
Industry participants and others have provided input to assist the Federal  Reserve in this effort. Based on the interviews we conducted, documents  we reviewed, and our analysis of the more than 280 comment letters  submitted to the Federal Reserve, issuers, consumer groups, and others  provided various suggestions to improve the content and format of credit  card disclosures, including:   Reduce the amount of information disclosed. Some industry  participants said that some of the information currently presented in the  Schumer box could be removed because it is too complicated to  disclose meaningfully or otherwise lacks importance compared to other  credit terms that are arguably more important when choosing among  cards. Such information included the method for computing balances  and the amount of the minimum finance charge (the latter because it is  typically so small, about 50 cents in 2005).
Provide a shorter document that summarizes key information. Some  industry participants advocated that all key information that could  significantly affect a cardholder’s costs be presented in a short  document that consumers could use to readily compare across cards,  with all other details included in a longer document. For example,  although the Schumer box includes several key pieces of information, it  does not include other information that could be as important for  consumer decisions, such as what actions could cause the issuer to raise  the interest rate to the default rate.
Revise disclosure formats to improve readability. Various suggestions  were made to improve the readability of card disclosures, including  making more use of tables of contents, making labels and headings more  prominent, and presenting more information in tables instead of in text.  Disclosure documents also could use consistent wording that could  allow for better comparison of terms across cards.
Some issuers and others also told us that the new regulations should allow  for more flexibility in card disclosure formats. Regulations mandating  formats and font sizes were seen as precluding issuers from presenting  information in more effective ways. For example, one issuer already has  conducted market research and developed new formats for the Schumer  box that it says are more readable and contain new information important  to choosing cards in today’s credit card environment, such as cardholder  actions that would trigger late fees or penalty interest rate increases.
In addition to suggestions about content, obtaining the input of consumers,  and possibly other professionals, was also seen as an important way to  make any new disclosures more useful. For example, participants in a  Federal Reserve Bank symposium on credit card disclosures recommended  that the Federal Reserve obtain the input of marketers, researchers, and  consumers as part of developing new disclosures. OCC staff suggested that  the Federal Reserve also employ qualitative research methods such as in- depth interviews with consumers and others and that it conduct usability  testing.
Consumer testing can validate the effectiveness or measure the  comprehension of messages and information, and detect document design  problems. Many issuers are using some form of market research to test  their disclosure materials and have advocated improving disclosures by  seeking the input of marketers, researchers, and consumers. SEC also has  recently used consumer focus groups to test the format of new disclosures  related to mutual funds. According to an SEC staff member who  participated in this effort, their testing provided them with valuable  information on what consumers liked and disliked about some of the initial  forms that the regulator had drafted. In some cases, they learned that  information that SEC staff had considered necessary to include was not  seen as important by consumers. As a result, they revised the formats for  these disclosures substantially to make them simpler and may use graphics  to present more information rather than text. According to Federal  Reserve staff, they have begun to involve consumers in the development of  new credit card disclosures. According to Federal Reserve staff, they have  already conducted some consumer focus groups. In addition, they have  contracted with a design consultant and a market research firm to help  them develop some disclosure formats that they can then use in one-on-one  testing with consumers. However, the Federal Reserve staff told us they  recognize the challenge of designing disclosures that include all key  information in a clear manner, given the complexity of credit card products  and the different ways in which consumers use credit cards.
section_title: Although Credit Card Penalty Fees and Interest Could Increase Indebtedness, the Extent to Which They Have Contributed to Bankruptcies Was Unclear
paragraphs: The number of consumers filing for bankruptcy has risen more than six- fold over the past 25 years, and various factors have been cited as possible  explanations. While some researchers have pointed to increases in total  debt or credit card debt in particular, others found that debt burdens and  other measures of financial distress had not increased and thus cite other  factors, such as a general decline in the stigma of going bankrupt or the  potentially increased costs of major life events such as health problems or  divorce. Some critics of the credit card industry have cited penalty interest  and fees as leading to increased financial distress; however, no  comprehensive data existed to determine the extent to which these charges  were contributing to consumer bankruptcies. Data provided by the six  largest card issuers indicated that unpaid interest and fees represented a  small portion of the amounts owed by cardholders that filed for  bankruptcy; however, these data alone were not sufficient to determine any  relationship between the charges and bankruptcies filed by cardholders.
subsections: section_title: Researchers Cited Various Factors as Explanations for Rise in Consumer Bankruptcies
paragraphs: According to U.S. Department of Justice statistics, consumer bankruptcy  filings generally rose steadily from about 287,000 in 1980 to more than 2  million as of December 31, 2005, which represents about a 609 percent  increase over the last 25 years. Researchers have cited a number of  factors as possible explanations for the long-term trend.
subsections: section_title: Increase in Household Indebtedness
paragraphs: The total debt of American households is composed of mortgages on real  estate, which accounts for about 80 percent of the total, and consumer  credit debt, which includes revolving credit, such as balances owed on  credit cards, and nonrevolving credit, primarily consisting of auto loans.  According to Federal Reserve statistics, consumers’ use of debt has  expanded over the last 25 years, increasing more than sevenfold from $1.4  trillion in 1980 to about $11.5 trillion in 2005. Some researchers pointed to  this rise in overall indebtedness as contributing to the rise in bankruptcies.  For example, a 2000 Congressional Budget Office summary of bankruptcy  research noted that various academic studies have argued that consumer  bankruptcies are either directly or indirectly caused by heavy consumer  indebtedness.
Rather than total debt, some researchers and others argue that the rise in  bankruptcies is related to the rise in credit card debt in particular.  According to the Federal Reserve’s survey of consumer debt, the amount of  credit card debt reported as outstanding rose from about $237 billion to  more than $802 billion—a 238 percent increase between 1990 and 2005.  One academic researcher noted that the rise in bankruptcies and charge- offs by banks in credit card accounts grew along with the increase in credit  card debt during the 1973 to 1996 period he examined. According to some  consumer groups, the growth of credit card debt is one of the primary  explanations of the increased prevalence of bankruptcies in the United  States. For example, one group noted in a 2005 testimony before Congress  that growth of credit card debt—particularly among lower and moderate  income households, consumers with poor credit scores, college students,  older Americans, and minorities—was contributing to the rise in  bankruptcies.
However, other evidence indicates that increased indebtedness has not  severely affected the financial condition of U.S. households in general. For  example:   Some researchers note that the ability of households to make payments  on debt appears to be keeping pace. For example, total household debt  levels as a percentage of income has remained relatively constant since  the 1980s. According to the Federal Reserve, the aggregate debt burden  ratio—which covers monthly aggregate required payments of all  households on mortgage debt and both revolving and non-revolving  consumer loans relative to the aggregate monthly disposable income of  all households—for U.S. households has been above 13 percent in the  last few years but generally fluctuated between 11 percent and 14  percent from 1990 to 2005, similar to the levels observed during the  1980s. According to one researcher, although the debt burden ratio has  risen since the 1980s, the increase has been gradual and therefore  cannot explain the six-fold increase in consumer bankruptcy filings over  the same period.
Credit card debt remains a small portion of overall household debt, even  among households with the lowest income levels. According to the  Federal Reserve, credit card balances as a percentage of total household  debt have declined from 3.9 percent of total household debt in 1995 to  just 3.0 percent as of 2004.
The proportion of households that could be considered to be in financial  distress does not appear to be increasing significantly. According to the  Federal Reserve Board’s Survey of Consumer Finances, the proportion  of households that could be considered to be in financial distress— those that report debt-to-income ratios exceeding 40 percent and that  have had at least one delinquent payment within the last 60 days—was  relatively stable between 1995 and 2004. Further, the proportion of the  lowest-income households exhibiting greater levels of distress was  lower in 2004 than it was in the 1990s.
section_title: Other Explanations
paragraphs: With the effect of increased debt unclear, some researchers say that other  factors may better explain the surge in consumer bankruptcy filings over  the past 25 years. For example, the psychological stigma of declaring  bankruptcy may have lessened. One academic study examined a range of  variables that measured the credit risk (risk of default) of several hundred  thousand credit card accounts and found that because the bankruptcy rate  for the accounts was higher than the credit-risk variables could explain, the  higher rate must be the result of a reduced level of stigma associated with  filing. However, others have noted that reliably measuring stigma is  difficult. Some credit card issuers and other industry associations also have  argued that the pre-2005 bankruptcy code was too debtor-friendly and  created an incentive for consumers to borrow beyond the ability to repay  and file for bankruptcy.
In addition to the possibly reduced stigma, some academics, consumer  advocacy groups, and others noted that the normal life events that reduce  incomes or increase expenses for households may have a more serious  effect today. Events that can reduce household incomes include job losses,  pay cuts, or having a full-time position converted to part-time work. With  increasing health care costs, medical emergencies can affect household  expenses and debts more significantly than in the past, and, with more  families relying on two incomes, so can divorces. As a result, one  researcher explains that while these risks have always faced households,  their effect today may be more severe, which could explain higher  bankruptcy rates.
Researchers who assert that life events are the primary explanation for  bankruptcy filings say that the role played by credit cards can vary. They  acknowledged that credit card debt can be a contributing factor to a  bankruptcy filing if a person’s income is insufficient to meet all financial  obligations, including payments to credit card issuers. For example, some  individuals experiencing an adverse life event use credit cards to provide  additional funds to satisfy their financial obligations temporarily but  ultimately exhaust their ability to meet all obligations. However, because  the number of people that experience financially troublesome life events  likely exceeds the number of people who file for bankruptcy, credit cards  in other cases may serve as a critical temporary source of funding they  needed to avert a filing until that person’s income recovers or expenses  diminish. (Appendix II provides additional detail about the factors that may  have affected the rise in consumer bankruptcy filings and its relationship  with credit card debt.)
section_title: The Extent to Which Credit Card Penalty Interest and Fees Contribute to Consumer Bankruptcies Remains Controversial in the Absence of Comprehensive Data
paragraphs: With very little information available on the financial condition of  individuals filing for bankruptcy, assessing the role played by credit card  debt, including penalty interest and fees, is difficult. According to  Department of Justice officials who oversee bankruptcy trustees in most  bankruptcy courts, the documents submitted as part of a bankruptcy filing  show the total debt owed to each card issuer but not how much of this total  consists of unpaid principal, interest, or fees. Similarly, these Justice  officials told us that the information that credit card issuers submit when  their customers reaffirm the debts owed to them—known as proofs of  claim—also indicate only the total amount owed. Likewise, the amount of  any penalty interest or fees owed as part of an outstanding credit card  balance is generally not required to be specified when a credit card issuer  seeks to obtain a court judgment that would require payment from a  customer as part of a collection case.
subsections: section_title: Opinions on the Link between Credit Card Practices and Bankruptcies Vary
paragraphs: Although little comprehensive data exist, some consumer groups and  others have argued that penalty interest and fees materially harm the  financial condition of some cardholders, including those that later file for  bankruptcy. Some researchers who study credit card issues argue that high  interest rates (applicable to standard purchases) for higher risk  cardholders, who are also frequently lower-income households, along with  penalty and default interest rates and fees, contribute to more consumer  bankruptcy filings. Another researcher who has studied issues relating to  credit cards and bankruptcy asserted that consumers focus too much on  the introductory purchase interest rates when shopping for credit cards  and, as a result, fail to pay close attention to penalty interest rates, default  clauses, and other fees that may significantly increase their costs later.  According to this researcher, it is doubtful that penalty fees (such as late  fees and over-limit fees) significantly affect cardholders’ debt levels, but  accrued interest charges—particularly if a cardholder is being assessed a  high penalty interest rate—can significantly worsen a cardholder’s financial  distress.
Some consumer advocacy groups and academics say that the credit card  industry practice of raising cardholder interest rates for default or  increased risky behavior likely has contributed to some consumer  bankruptcy filings. According to these groups, cardholders whose rates are  raised under such practices can find it more difficult to reduce their credit  card debt and experience more rapid declines in their overall financial  conditions as they struggle to make the higher payments that such interest  rates may entail. As noted earlier in this report, card issuers have generally  ceased practicing universal default, although representatives for four of the  six issuers told us that they might increase their cardholder’s rates if they  saw indications that the cardholder’s risk has increased, such as how well  they were making payments to other creditors. In such cases, the card  issuers said they notify the cardholders in advance, by sending a change in  terms notice, and provide an option to cancel the account but keep the  original terms and conditions while paying off the balance.
Some organizations also have criticized the credit card industry for  targeting lower-income households that they believe may be more likely to  experience financial distress or file for bankruptcy. One of the criticisms  these organizations have made is that credit card companies have been  engaging in bottom-fishing by providing increasing amounts of credit to  riskier lower-income households that, as a result, may incur greater levels  of indebtedness than appropriate. For example, an official from one  consumer advocacy group testified in 2005 that card issuers target lower- income and minority households and that this democratization of credit  has had serious negative consequences for these households, placing them  one financial emergency away from having to file for bankruptcy. Some  consumer advocacy group officials and academics noted that card issuers  market high-cost cards, with higher interest rates and fees, to customers  with poor credit histories—called subprime customers—including some  just coming out of bankruptcy. However, as noted earlier, Federal Reserve  survey data indicate that the proportion of lower-income households— those with incomes below the fortieth percentile—exhibiting financial  distress has not increased since 1995. In addition, in a June 2006 report that  the Federal Reserve Board prepared for Congress on the relationship  between credit cards and bankruptcy, it stated that credit card issuers do  not solicit customers or extend credit to them indiscriminately or without  assessing their ability to repay debt as issuers review all received  applications for risk factors.
In addition, representatives of credit card issuers argued that they do not  offer credit to those likely to become financially bankrupt because they do  not want to experience larger losses from higher-risk borrowers. Because  card accounts belonging to cardholders that filed for bankruptcy account  for a sizeable portion of issuers’ charge-offs, card issuers do not want to  acquire new customers with high credit risk who may subsequently file for  bankruptcy. However, one academic researcher noted that, if card issuers  could increase their revenue and profits by offering cards to more  customers, including those with lower creditworthiness, they could  reasonably be expected to do so until the amount of expected losses from  bankruptcies becomes larger than the expected additional revenues from  the new customers.
In examining the relationship between the consumer credit industry and  bankruptcy, the Federal Reserve Board’s 2006 report comes to many of the  same conclusions as the studies of other researchers we reviewed. The  Federal Reserve Board’s report notes that despite large growth in the  proportion of households with credit cards and the rise in overall credit  card debt in recent decades, the debt-burden ratio and other potential  measures of financial distress have not significantly changed over this  period. The report also found that, while data on bankruptcy filings  indicate that most filers have accumulated consumer debt and the  proportion of filings and rise in revolving consumer debt have risen in  tandem, the decision to file for bankruptcy is complex and tends to be  driven by distress arising from life events such as job loss, divorce, or  uninsured illness.
section_title: Penalty Interest and Fees Can Affect Cardholders’ Ability to Reduce Outstanding Balances
paragraphs: While the effect of credit card penalty interest charges and fees on  consumer bankruptcies was unclear, such charges do reduce the ability of  cardholders to reduce their overall indebtedness. Generally, any penalty  charges that cardholders pay would consume funds that could have been  used to repay principal. Figure 16 below, compares two hypothetical  cardholders with identical initial outstanding balances of $2,000 that each  make monthly payments of $100. The figure shows how the total amounts  of principal are paid down by each of these two cardholders over the  course of 12 months, if penalty interest and fees apply. Specifically,  cardholder A (1) is assessed a late payment fee in three of those months  and (2) has his interest rate increased to a penalty rate of 29 percent after 6  months, while cardholder B does not experience any fees or penalty  interest charges. At the end of 12 months, the penalty and fees results in  cardholder A paying down $260 or 27 percent less of the total balance owed  than does cardholder B who makes on-time payments for the entire period.
In reviewing academic literature, hearings, and comment letters to the  Federal Reserve, we identified some court cases, including some involving  the top six issuers, that indicated that cardholders paid large amounts of  penalty interest and fees. For example:   In a collections case in Ohio, the $1,963 balance on one cardholder’s  credit card grew by 183 percent to $5,564 over 6 years, despite the  cardholder making few new purchases. According to the court’s  records, although the cardholder made payments totaling $3,492 over  this period, the holder’s balance grew as the result of fees and interest  charges. According to the court’s determinations, between 1997 and  2003, the cardholder was assessed a total of $9,056, including $1,518 in  over-limit fees, $1,160 in late fees, $369 in credit insurance, and $6,009 in  interest charges and other fees. Although the card issuer had sued to  collect, the judge rejected the issuer’s collection demand, noting that the  cardholder was the victim of unreasonable, unconscionable practices.
In a June 2004 bankruptcy case filed in the U.S. Bankruptcy Court for  the Eastern District of Virginia, the debtor objected to the proofs of  claim filed by two companies that had been assigned the debt  outstanding on two of the debtor’s credit cards. One of the assignees  submitted monthly statements for the credit card account it had  assumed. The court noted that over a two-year period (during which  balance on the account increased from $4,888 to $5,499), the debtor  made only $236 in purchases on the account, while making $3,058 in  payments, all of which had gone to pay finance charges, late charges,  over-limit fees, bad check fees and phone payment fees.
In a bankruptcy court case filed in July 2003 in North Carolina, 18  debtors filed objections to the claims by one card issuer of the amounts  owed on their credit cards. In response to an inquiry by the judge, the  card issuer provided data for these accounts that showed that, in the  aggregate, 57 percent of the amounts owed by these 18 accounts at time  of their bankruptcy filings represented interest charges and fees.  However, the high percentage of interest and fees on these accounts  may stem from the size of these principal balances, as some were as low  as $95 and none was larger than $1,200.
Regulatory interagency guidance published in 2003 for all depository  institutions that issue credit cards may have reduced the potential for  cardholders who continue to make minimum payments to experience  increasing balances. In this guidance, regulators suggested that card  issuers require minimum repayment amounts so that cardholders’ current  balance would be paid off–amortized–over a reasonable amount of time. In  the past, some issuers’ minimum monthly payment formulas were such that  a full payment may have resulted in little or no principal being paid down,  particularly if the cardholder also was assessed any fees during a billing  cycle. In such cases, these cardholders’ outstanding balances would  increase (or negatively amortize). In response to this guidance, some card  issuers we interviewed indicated that they have been changing their  minimum monthly payment formulas to ensure that credit card balances  will be paid off over a reasonable period by including at least some amount  of principal in each payment due.
Representatives of card issuers also told us that the regulatory guidance,  issued in 2003, addressing credit card workout programs—which allow a  distressed cardholder’s account to be closed and repaid on a fixed  repayment schedule—and other forbearance practices, may help  cardholders experiencing financial distress avoid fees. In this guidance, the  regulators stated that (1) any workout program offered by an issuer should  be designed to have cardholders repay credit card debt within 60 months  and (2) to meet this time frame, interest rates and penalty fees may have to  be substantially reduced or eliminated so that principal can be repaid. As a  result, card issuers are expected to stop imposing penalty fees and interest  charges on delinquent card accounts or hardship card accounts enrolled in  repayment workout programs. According to this guidance, issuers also can  negotiate settlement agreements with cardholders by forgiving a portion of  the amount owed. In exchange, a cardholder can be expected to pay the  remaining balance either in a lump-sum payment or by amortizing the  balance over a several month period. Staff from OCC and an association of  credit counselors told us that, since the issuance of this guidance, they  have noticed that card issuers are increasingly both reducing and waiving  fees for cardholders who get into financial difficulty. OCC officials also  indicated that issuers prefer to facilitate repayment of principal when  borrowers adopt debt management plans and tend to reduce or waive fees  so the accounts can be amortized. On the other hand, FDIC staff indicated  that criteria for waiving fees and penalties are not publicly disclosed to  cardholders. These staff noted that most fee waivers occurs after  cardholders call and complain to the issuer and are handled on a case-by- case basis.
section_title: Data for Some Bankrupt Cardholders Shows Little in Interest and Fees Owed, but Comprehensive Data Were Not Available
paragraphs: Card issuers generally charge-off credit card loans that are no longer  collectible because they are in default for either missing a series of  payments or filing for bankruptcy. According to the data provided by the  six largest issuers, the number of accounts that these issuers collectively  had to charge off as a result of the cardholders filing for bankruptcy ranged  from about 1.3 million to 1.6 million annually between 2003 and 2005.  Collectively, these represented about 1 percent of the six issuers’ active  accounts during this period. Also, about 60 percent of the accounts were 2  or more months delinquent at the time of the charge-off. Most of the  cardholders whose accounts were charged off as the result of a bankruptcy  owed small amounts of fees and interest charges at the time of their  bankruptcy filing. According to the data the six issuers provided, the  average account that they charged off in 2005 owed approximately $6,200  at the time that bankruptcy was filed. Of this amount, the issuers reported  that on average 8 percent represented unpaid interest charges; 2 percent  unpaid fees, including any unpaid penalty charges; and about 90 percent  principal.
However, these data do not provide complete information about the extent  to which the financial condition of the cardholders may have been affected  by penalty interest and fee charges. First, the amounts that these issuers  reported to us as interest and fees due represent only the unpaid amounts  that were owed at the time of bankruptcy. According to representatives of  the issuers we contacted, each of their firms allocates the amount of any  payment received from their customers first to any outstanding interest  charges and fees, then allocates any remainder to the principal balance. As  a result, the amounts owed at the time of bankruptcy would not reflect any  previously paid fees or interest charges. According to representatives of  these issuers, data system and recordkeeping limitations prevented them  from providing us the amounts of penalty interest and fees assessed on  these accounts in the months prior to the bankruptcy filings.
Furthermore, the data do not include information on all of the issuers’  cardholders who went bankrupt, but only those whose accounts the issuers  charged off as the result of a bankruptcy filing. The issuers also charge off  the amounts owed by customers who are delinquent on their payments by  more than 180 days, and some of those cardholders may subsequently file  for bankruptcy. Such accounts may have accrued larger amounts of unpaid  penalty interest and fees than the accounts that were charged off for  bankruptcy after being delinquent for less than 180 days, because they  would have had more time to be assessed such charges. Representatives of  the six issuers told us that they do not maintain records on these customers  after they are charged off, and, in many cases, they sell the accounts to  collection firms.
section_title: Although Penalty Interest and Fees Likely Have Grown as a Share of Credit Card Revenues, Large Card Issuers’ Profitability Has Been Stable
paragraphs: Determining the extent to which penalty interest charges and fees  contribute to issuers’ revenues and profits was difficult because issuers’  regulatory filings and other public sources do not include such detail.  According to bank regulators, industry analysts, and information reported  by the five largest issuers, we estimate that the majority of issuer  revenues—around 70 percent in recent years—came from interest charges,  and the portion attributable to penalty rates appears to be growing. Of the  remaining issuer revenues, penalty fees had increased and were estimated  to represent around 10 percent of total issuer revenues. The remainder of  issuer revenues came from fees that issuers receive for processing  merchants’ card transactions and other types of consumer fees. The largest  credit card-issuing banks, which are generally the most profitable group of  lenders, have not greatly increased their profitability over the last 20 years.
subsections: section_title: Publicly Disclosed Data on Revenues and Profits from Penalty Interest and Fees Are Limited
paragraphs: Determining the extent to which penalty interest and fee charges are  contributing to card issuer revenues and profits is difficult because limited  information is available from publicly disclosed financial information.  Credit card-issuing banks are subject to various regulations that require  them to publicly disclose information about their revenues and expenses.  As insured commercial banks, these institutions must file reports of their  financial condition, known as call reports, each quarter with their  respective federal regulatory agency. In call reports, the banks provide  comprehensive balance sheets and income statements disclosing their  earnings, including those from their credit card operations. Although the  call reports include separate lines for interest income earned, this amount  is not further segregated to show, for example, income from the application  of penalty interest rates. Similarly, banks report their fee income on the call  reports, but this amount includes income from all types of fees, including  those related to fiduciary activities, and trading assets and liabilities and is  not further segregated to show how much a particular bank has earned  from credit card late fees, over-limit fees, or insufficient payment fees.
Another limitation of using call reports to assess the effect of penalty  charges on bank revenues is that these reports do not include detailed  information on credit card balances that a bank may have sold to other  investors through a securitization. As a way of raising additional funds to  lend to cardholders, many issuers combine the balances owed on large  groups of their accounts and sell these receivables as part of pools of  securitized assets to investors. In their call reports, the banks do not report  revenue received from cardholders whose balances have been sold into  credit card interest and fee income categories. The banks report any gains  or losses incurred from the sale of these pooled credit card balances on  their call reports as part of noninterest income. Credit card issuing banks  generally securitize more than 50 percent of their credit card balances.
Although many card issuers, including most of the top 10 banks, are public  companies that must file various publicly available financial disclosures on  an ongoing basis with securities regulators, these filings also do not  disclose detailed information about penalty interest and fees. We reviewed  the public filings by the top five issuers and found that none of the financial  statements disaggregated interest income into standard interest and  penalty interest charges. In addition, we found that the five banks’ public  financial statements also had not disaggregated their fee income into  penalty fees, service fees, and interchange fees. Instead, most of these card  issuers disaggregated their sources of revenue into two broad categories— interest and noninterest income.
section_title: Majority of Card Issuer Revenues Came from Interest Charges
paragraphs: Although limited information is publicly disclosed, the majority of credit  card revenue appears to have come from interest charges. According to  regulators, information collected by firms that analyze the credit card  industry, and data reported to us by the five of the six largest issuers, the  proportion of net interest revenues to card issuers’ total revenues is as  much as 71 percent. For example, five of the six largest issuers that  provided data to us reported that the proportion of their total U.S. card  operations income derived from interest charges ranged from 69 to 71  percent between 2003 and 2005.
We could not precisely determine the extent to which penalty interest  charges contribute to this revenue, although the amount of penalty interest  that issuers have been assessing has increased. In response to our request,  the six largest issuers reported the proportions of their total cardholder  accounts that were assessed various rates of interest for 2003 to 2005. On  the basis of our analysis of the popular cards issued by these largest  issuers, all were charging, on average, default interest rates of around 27  percent. According to the data these issuers provided, the majority of  cardholders paid interest rates below 20 percent, but the proportion of  their cardholders that paid interest rates at or above 25 percent—which  likely represent default rates—has risen from 5 percent in 2003 to 11  percent in 2005. As shown in Figure 18, the proportion of cardholders  paying between 15 and 20 percent has also increased, but an issuer  representative told us that this likely was due to variable interest rates on  cards rising as a result of increases in U.S. market interest rates over the  last 3 years.
Although we could not determine the amounts of penalty interest the card  issuers received, the increasing proportion of accounts assessed rates of 25  percent suggests a significant increase in interest revenues. For example, a  cardholder carrying a stable balance of $1,000 and paying 10 percent  interest would pay approximately $100 annually, while a cardholder  carrying the same stable balance but paying 25 percent would pay $250 to  the card issuer annually. Although we did not obtain any information on the  size of balances owed by the cardholders of the largest issuers, the  proportion of the revenues these issuers received from cardholders paying  penalty interest rates may also be greater than 11 percent because such  cardholders may have balances larger than the $2,500 average for 2005 that  the issuers reported to us.
section_title: Fees Represented the Remainder of Issuer Revenues
paragraphs: The remaining card issuer revenues largely come from noninterest sources,  including merchant and consumer fees. Among these are penalty fees and  other consumer fees, as well as fees that issuers receive as part of  processing card transactions for merchants.
subsections: section_title: Penalty Fees Had Increased
paragraphs: Although no comprehensive data exist publicly, various sources we  identified indicated that penalty fees represent around 10 percent of  issuers’ total revenues and had generally increased. We identified various  sources that gave estimates of penalty fee income as a percentage of card  issuers’ total revenues that ranged from 9 to 13 percent:  Analysis of the data the top six issuers provided to us indicated that  each of these issuers assessed an average of about $1.2 billion in penalty  fees for cardholders that made late payments or exceeded their credit  limit in 2005. In total, these six issuers reported assessing $7.4 billion for  these two penalty fees that year, about 12 percent of the $60.3 billion in  total interest and consumer fees (penalty fees and fees for other  cardholder services).
According to a private firm that assists credit card banks with buying  and selling portfolios of credit card balance receivables, penalty fees  likely represented about 13 percent of total card issuer revenues.  According to an official with this firm, it calculated this estimate by  using information from 15 of the top 20 issuers, as well as many smaller  banks, that together represent up to 80 percent of the total credit card  industry.
An estimate from an industry research firm that publishes data on credit  card issuer activities indicated that penalty fees represented about 9  percent of issuer total revenues.
section_title: Issuers Also Collect Revenues from Processing Merchant Card Transactions
paragraphs: When a consumer makes a purchase with a credit card, the merchant  selling the goods does not receive the full purchase price. When the  cardholder presents the credit card to make a purchase, the merchant  transmits the cardholder’s account number and the amount of the  transaction to the merchant’s bank. The merchant’s bank forwards this  information to the card association, such as Visa or Mastercard, requesting  authorization for the transaction. The card association forwards the  authorization request to the bank that issued the card to the cardholder.  The issuing bank then responds with its authorization or denial to the  merchant’s bank and then to the merchant. After the transaction is  approved, the issuing bank will send the purchase amount, less an  interchange fee, to the merchant’s bank. The interchange fee is established  by the card association. Before crediting the merchant’s account, the  merchant’s bank will subtract a servicing fee. These transaction fees— called interchange fees—are commonly about 2 percent of the total  purchase price. As shown in figure 19, the issuing banks generally earn  about $2.00 for every $100 purchased as interchange fee revenue. In  addition, the card association receives a transaction processing fee. The  card associations, such as Visa or Mastercard, assess the amount of these  fees and also conduct other important activities, including imposing rules  for issuing cards, authorizing, clearing and settling transactions,  advertising and promoting the network brand, and allocating revenues  among the merchants, merchant’s bank, and card issuer.
In addition to penalty fees and interchange fees, the remaining noninterest  revenues for card issuers include other consumer fees or other fees. Card  issuers collect annual fees, cash advance fees, balance transfer fees, and  other fees from their cardholders. In addition, card issuers collect other  revenues, such as from credit insurance. According to estimates by  industry analyst firms, such revenues likely represented about 8 to 9  percent of total issuer revenues.
section_title: Large Credit Card Issuer Profitability Has Been Stable
paragraphs: The profits of credit card-issuing banks, which are generally the most  profitable group of lenders, have been stable over the last 7 years. A  commonly used indicator of profitability is the return on assets ratio  (ROA). This ratio, which is calculated by dividing a company's income by  its total assets, shows how effectively a business uses its assets to generate  profits. In annual reports to Congress, the Federal Reserve provides data  on the profitability of larger credit card issuers—which included 17 banks  in 2004. Figure 20 shows the average ROA using pretax income for these  large credit card issuers compared with pretax ROA of all commercial  banks during the period 1986 to 2004. In general, the large credit card  issuers earned an average return of 3.12 percent over this period, which  was more than twice as much as the 1.49 percent average returns earned by  all commercial banks.
As shown in the figure above, the ROA for larger credit card banks,  although fluctuating more widely during the 1990s, has generally been  stable since 1999, with returns in the 3.0 to 3.5 percent range. The return on  assets for the large card issuers peaked in 1993 at 4.1 percent and has  declined to 3.55 percent in 2004. In contrast, the profitability of all  commercial banks has been generally increasing over this period, rising  more than 140 percent between 1986 and 2004. Similar to the data for all  larger credit card issuers, data that five of the six largest issuers provided  to us indicated that their profitability also has been stable in the 3 years  between 2003 and 2005. These five issuers reported that the return on their  pretax earnings over their credit card balances over this 3-year period  ranged from about 3.6 percent to 4.1 percent.
Because of the high interest rates that issuers charge and variable rate  pricing, credit card lending generally is the most profitable type of  consumer lending, despite the higher rate of loan losses that issuers incur  on cards. Rates charged on credit cards generally are the highest of any  consumer lending category because they are extensions of credit that are  not secured by any collateral from the borrower. In contrast, other  common types of consumer lending, such as automobile loans or home  mortgages, involve the extension of a fixed amount of credit under fixed  terms of repayment that are secured by the underlying asset—the car or the  house—which the lender can repossess in the event of nonpayment by the  borrower. Collateral and fixed repayment terms reduce the risk of loss to  the lender, enabling them to charge lower interest rates on such loans. In  contrast, credit card loans, which are unsecured, available to large and  heterogeneous populations, and repayable on flexible terms at the  cardholders’ convenience, present greater risks and have commensurately  higher interest rates. For example, according to Federal Reserve statistics,  the interest rate charged on cards by lenders generally has averaged above  16 percent since 1980, while the average rate charged on car loans since  then has averaged around 10 percent. Borrowers may be more likely to  cease making payments on their credit cards if they become financially  distressed than they would on other loans that are secured by an asset they  could lose. For example, the percentage of credit card loans that banks  have had to charge off averaged above 4 percent between 2003 and 2005; in  contrast, charge-offs for other types of consumer loans average about 2  percent, with charge-offs for mortgage loans averaging less than 1 percent,  during those 3 years. (App. III provides additional detail about the factors  that affect the profitability of credit card issuers.)
section_title: Conclusions
paragraphs: Credit cards provide various benefits to their cardholders, including  serving as a convenient way to pay for goods and services and providing  additional funds at rates of interest generally lower than those consumers  would have paid to borrow on cards in the past. However, the penalties for  late payments or other behaviors involving card use have risen significantly  in recent years. Card issuers note that their use of risk-based pricing  structures with multiple interest rates and fees has allowed them to offer  credit cards to cardholders at costs that are commensurate with the risks  presented by different types of customers, including those who previously  might not have been able to obtain credit cards. On the whole, a large  number of cardholders experience greater benefits—either by using their  cards for transactions without incurring any direct expense or by enjoying  generally lower costs for borrowing than prevailed in the past—from using  credit cards than was previously possible, but the habits or financial  circumstances of other cardholders also could result in these consumers  facing greater costs than they did in the past.
The expansion and increased complexity of card rates, fees, and issuer  practices has heightened the need for consumers to receive clear  disclosures that allow them to more easily understand the costs of using  cards. In the absence of any regulatory or legal limits on the interest or fees  that cards can impose, providing consumers with adequate information on  credit card costs and practices is critical to ensuring that vigorous  competition among card issuers produces a market that provides the best  possible rates and terms for U.S. consumers. Our work indicates that the  disclosure materials that the largest card issuers typically provided under  the existing regulations governing credit cards had many serious  weaknesses that reduced their usefulness to the consumers they are  intended to help. Although these regulations likely were adequate when  card rates and terms were less complex, the disclosure materials they  produce for cards today, which have a multitude of terms and conditions  that can affect cardholders’ costs, have proven difficult for consumers to  use in finding and understanding important information about their cards.  Although providing some key information, current disclosures also give  prominence to terms, such as minimum finance charge or balance  computation method, that are less significant to consumers’ costs and do  not adequately emphasize terms such as those cardholder actions that  could cause their card issuer to raise their interest rate to a high default  rate. Because part of the reason that current disclosure materials may be  less effective is that they were designed in an era when card rates and  terms were less complex, the Federal Reserve also faces the challenge of  creating disclosure requirements that are more flexible to allow them to be  adjusted more quickly as new card features are introduced and others  become less common.
The Federal Reserve, which has adopted these regulations, has recognized  these problems, and its current review of the open-end credit rules of  Regulation Z presents an opportunity to improve the disclosures applicable  to credit cards. Based on our work, we believe that disclosures that are  simpler, better organized, and use designs and formats that comply with  best practices and industry standards for readability and usability would be  more effective. Our work and the experiences of other regulators also  confirmed that involving experts in readability and testing documents with  actual consumers can further improve any resulting disclosures. The  Federal Reserve has indicated that it has begun to involve consumers in the  design of new model disclosures, but it has not completed these efforts to  date, and new model disclosures are not expected to be issued until 2007 or  2008. Federal Reserve staff noted that they recognize the challenge of how  best to incorporate the variety of information that consumers may need to  understand the costs of their cards in clear and concise disclosure  materials. Until such efforts are complete, consumers will continue to face  difficulties in using disclosure materials to better understand and compare  costs of credit cards. In addition, until more understandable disclosures are  issued, the ability of well-informed consumers to spur additional  competition among issuers in credit card pricing is hampered.
Definitively determining the extent to which credit card penalty interest  and fees contribute to personal bankruptcies and the profits and revenues  of card issuers is difficult given the lack of comprehensive, publicly  available data. Penalty interest and fees can contribute to the total debt  owed by cardholders and decrease the funds that a cardholder could have  used to reduce debt and possibly avoid bankruptcy. However, many  consumers file for bankruptcy as the result of significant negative life  events, such as divorces, job losses, or health problems, and the role that  credit cards play in avoiding or accelerating such filings is not known.  Similarly, the limited available information on card issuer operations  indicates that penalty fees and interest are a small but growing part of such  firms’ revenues. With the profitability of the largest card issuers generally  being stable over recent years, the increased revenues gained from penalty  interest and fees may be offsetting the generally lower amounts of interest  that card issuers collect from the majority of their cardholders. These  results appear to indicate that while most cardholders likely are better off,  a smaller number of cardholders paying penalty interest and fees are  accounting for more of issuer revenues than they did in the past. This  further emphasizes the importance of taking steps to ensure that all  cardholders receive disclosures that help them clearly understand their  card costs and how their own behavior can affect those costs.
section_title: Recommendation for Executive Action
paragraphs: As part of its effort to increase the effectiveness of disclosure materials  used to inform consumers of rates, fees, and other terms that affect the  costs of using credit cards, the Chairman, Federal Reserve should ensure  that such disclosures, including model forms and formatting requirements,  more clearly emphasize those terms that can significantly affect cardholder  costs, such as the actions that can cause default or other penalty pricing  rates to be imposed.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Federal Reserve, OCC, FDIC, the  Federal Trade Commission, the National Credit Union Administration, and  the Office of Thrift Supervision for their review and comment. In a letter  from the Federal Reserve, the Director of the Division of Consumer and  Community Affairs agreed with the findings of our report that credit card  pricing has become more complex and that the disclosures required under  Regulation Z could be improved with the input of consumers. To this end,  the Director stated that the Board is conducting extensive consumer  testing to identify the most important information to consumers and how  disclosures can be simplified to reduce current complexity. Using this  information, the Director said that the Board would develop new model  disclosure forms with the assistance of design consultants. If appropriate,  the Director said the Board may develop suggestions for statutory changes  for congressional consideration.
We also received technical comments from the Federal Reserve and OCC,  which we have incorporated in this report as appropriate. FDIC, the  Federal Trade Commission, the National Credit Union Administration, and  the Office of Thrift Supervision did not provide comments.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after the  date of this report. At that time, we will send copies of this report to the  Chairman, Permanent Subcommittee on Investigations, Senate Committee  on Homeland Security and Governmental Affairs; the Chairman, FDIC; the  Chairman, Federal Reserve; the Chairman, Federal Trade Commission; the  Chairman, National Credit Union Administration; the Comptroller of the  Currency; and the Director, Office of Thrift Supervision and to interested  congressional committees. We will also make copies available to others  upon request. The report will be available at no charge on the GAO Web site  at http://www.gao.gov.
If you or your staff have any questions regarding this report, please contact  me at (202) 512-8678 or woodd@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix IV.
section_title: Objectives, Scope and Methodology
paragraphs: Our objectives were to determine (1) how the interest, fees, and other  practices that affect the pricing structure of cards from the largest U.S.  issuers have evolved, and cardholders’ experiences under these pricing  structures in recent years; (2) how effectively the issuers disclose the  pricing structures of cards to their cardholders; (3) whether credit card  debt and penalty interest and fees contribute to cardholder bankruptcies;  and (4) the extent to which penalty interest and fees contribute to the  revenues and profitability of issuers’ credit card operations.
subsections: section_title: Methodology for Identifying the Evolution of Pricing Structures
paragraphs: To identify how the pricing structure of cards from the largest U.S. issuers  has evolved, we analyzed disclosure documents from 2003 to 2005 for 28  popular cards that were issued by the six largest U.S. card issuers, as  measured by total outstanding receivables as of December 31, 2004   (see fig. 2 in the body of this report). These issuers were Bank of America;  Capital One Bank; Chase Bank USA, N.A.; Citibank (South Dakota), N.A.;  Discover Financial Services; and MBNA America Bank, N.A.  Representatives for these six issuers identified up to five of their most  popular cards and provided us actual disclosure materials, including  cardmember agreements and direct mail applications and solicitations  used for opening an account for each card. We calculated descriptive  statistics for various interest rates and fees and the frequency with which  cards featured other practices, such as methods for calculating finance  charges. We determined that these cards likely represented the pricing and  terms that applied to the majority of U.S. cardholders because the top six  issuers held almost 80 percent of consumer credit card debt and as much as  61 percent of total U.S. credit card accounts.
We did not include in our analysis of popular cards any cards offered by  credit card issuers that engage primarily in subprime lending. Subprime  lending generally refers to extending credit to borrowers who exhibit  characteristics indicating a significantly higher risk of default than  traditional bank lending customers. Such issuers could have pricing  structures and other terms significantly different to those of the popular  cards offered by the top issuers. As a result, our analysis may  underestimate the range of interest rate and fee levels charged on the entire  universe of cards. To identify historical rate and fee levels, we primarily  evaluated the Federal Reserve Board’s G.19 Consumer Credit statistical  release for 1972 to 2005 and a paper written by a Federal Reserve Bank  staff, which included more than 150 cardmember agreements from 15 of  the largest U.S. issuers in 1997 to 2002.
To evaluate cardholders’ experiences with credit card pricing structures in  recent years, we obtained proprietary data on the extent to which issuers  assessed various interest rate levels and fees for active accounts from the  six largest U.S. issuers listed above for 2003, 2004, and 2005. We obtained  data directly from issuers because no comprehensive sources existed to  show the extent to which U.S. cardholders were paying penalty interest  rates. Combined, these issuers reported more than 180 million active  accounts, or about 60 percent of total active accounts reported by  CardWeb.com, Inc. These accounts also represented almost $900 billion in  credit card purchases in 2005, according to these issuers. To preserve the  anonymity of the data, these issuers engaged legal counsel at the law firm  Latham & Watkins, LLP, to which they provided their data on interest rate  and fee assessments, which then engaged Argus Information and Advisory  Services, LLC, a third-party analytics firm, to aggregate the data, and then  supplied it to us. Although we originally provided a more comprehensive  data request to these issuers, we agreed to a more limited request with  issuer representatives as a result of these firms’ data availability and  processing limitations. We discussed steps that were taken to attempt to  ensure that the data provided to us were complete and accurate with  representatives of these issuers and the third party analytics firm. We also  shared a draft of this report with the supervisory agencies of these issuers.  However, we did not have access to the issuers’ data systems to fully assess  the reliability of the data or the systems that housed them. Therefore, we  present these data in our report only as representations made to us by the  six largest issuers.
section_title: Methodology for Assessing Effectiveness of Disclosures
paragraphs: To determine how effectively card issuers disclose to cardholders the rates,  fees, and other terms related to their credit cards, we contracted with  UserWorks, Inc., a private usability consulting firm, which conducted three  separate evaluations of a sample of disclosure materials. We provided the  usability consultant with a cardmember agreement and solicitation letter  for one card from four representative credit card issuers—a total of four  cards and eight disclosure documents. The first evaluation, a readability  assessment, used computer-facilitated formulas to predict the grade level  required to understand the materials. Readability formulas measure the  elements of writing that can be subjected to mathematical calculation, such  as average number of syllables in words or numbers of words in sentences  in the text. The consultant applied the following industry-standard  formulas to the documents: Flesch Grade Level, Frequency of  Gobbledygook (FOG), and the Simplified Measure of Gobbledygook  (SMOG). Using these formulas, the consultant measured the grade levels at  which the disclosure documents were written overall, as well as for  selected sections. Secondly, the usability consultant conducted an heuristic  evaluation that assessed how well these card disclosure documents  adhered to a recognized set of principles or industry best practices. In the  absence of best practices specifically applicable to credit card disclosures,  the consultant used guidelines from the U.S. Securities and Exchange  Commission’s 1998 guidebook Plain English Handbook: How to Create  Clear SEC Disclosure Documents.
Finally, the usability consultant tested how well actual consumers were  able to use the documents to identify and understand information about  card fees and other practices and used the results to identify problem  areas. The consultant conducted these tests with 12 consumers. To ensure  sample diversity, the participants were selected to represent the  demographics of the U.S. adult population in terms of education, income,  and age. While the materials used for the readability and usability  assessments appeared to be typical of the large issuers’ disclosures, the  results cannot be generalized to materials that were not reviewed.
To obtain additional information on consumers’ level of awareness and  understanding of their key credit card terms, we also conducted in-depth,  structured interviews in December 2005 with a total of 112 adult  cardholders in three locations: Boston, Chicago, and San Francisco. We  contracted with OneWorld Communications, Inc., a market research  organization, to recruit a sample of cardholders that generally resembled  the demographic makeup of the U.S. population in terms of age, education  levels, and income. However, the cardholders recruited for the interviews  did not form a random, statistically representative sample of the U.S.  population and therefore cannot be generalized to the population of all U.S.  cardholders. Cardholders had to speak English, have owned at least one  general-purpose credit card for a minimum of 12 months, and have not  participated in more than one focus group or similar in-person study in the  12 months prior to the interview. We gathered information about the  cardholders’ knowledge of credit card terms and conditions, and assessed  cardholders’ use of card disclosure materials by asking them a number of  open- and closed-ended questions.
section_title: Methodology for Determining How Penalty Charges Contribute to Bankruptcy
paragraphs: To determine whether credit card debt and penalty interest and fees  contribute to cardholder bankruptcies, we interviewed Department of  Justice staff responsible for overseeing bankruptcy courts and trustees  about the availability of data on credit card penalty charges in materials  submitted by consumers or issuers as part of bankruptcy filings or  collections cases. We also interviewed two attorneys that assist consumers  with bankruptcy filings. In addition, we reviewed studies that analyzed  credit card and bankruptcy issues published by various academic  researchers, the Congressional Research Service, and the Congressional  Budget Office. We did not attempt to assess the reliability of all of these  studies to the same, full extent. However, because of the prominence of  some of these data sources, and frequency of use of this data by other  researchers, as well as the fact that much of the evidence is corroborated  by other evidence, we determined that citing these studies was appropriate.
We also analyzed aggregated card account data provided by the six largest  issuers (as previously discussed) to measure the amount of credit card  interest charges and fees owed at the time these accounts were charged off  as a result of becoming subject to bankruptcy filing. We also spoke with  representatives of the largest U.S. credit card issuers, as well as  representatives of consumer groups and industry associations, and with  academic researchers that conduct analysis on the credit card industry.
section_title: Methodology for Determining How Penalty Charges Contribute to Issuer Revenues
paragraphs: To determine the extent to which penalty interest and fees contributed to  the revenues and profitability of issuers’ credit card operations, we  reviewed the extent to which penalty charges are disclosed in bank  regulatory reports—the call reports—and in public disclosures—such as  annual reports (10-Ks) and quarterly reports (10-Qs) made by publicly  traded card issuers. We analyzed data reported by the Federal Reserve on  the profitability of commercial bank card issuers with at least $200 million  in yearly average assets (loans to individuals plus securitizations) and at  least 50 percent of assets in consumer lending, of which 90 percent must be  in the form of revolving credit. In 2004, the Federal Reserve reported that  17 banks had card operations with at least this level of activity in 2004. We  also analyzed information from the Federal Deposit Insurance Corporation,  which analyzes data for all federally insured banks and savings institutions  and publishes aggregated data on those with various lending activity  concentrations, including a group of 33 banks that, as of December 2005,  had credit card operations that exceeded 50 percent of their total assets  and securitized receivables.
We also analyzed data reported to us by the six largest card issuers on their  revenues and profitability of their credit card operations for 2003, 2004, and  2005. We also reviewed data on revenues compiled by industry analysis  firms, including Card Industry Directory published by Sourcemedia, and  R.K. Hammer. Because of the proprietary nature of their data,  representatives for Sourcemedia and R.K. Hammer were not able to  provide us with information sufficient for us to assess the reliability of their  data. However, we analyzed and presented some information from these  sources because we were able to corroborate their information with each  other and with data from sources of known reliability, such as regulatory  data, and we attribute their data to them.
We also interviewed broker-dealer financial analysts who monitor activities  by credit card issuers to identify the extent to which various sources of  income contribute to card issuers’ revenues and profitability. We attempted  to obtain the latest in a series of studies of card issuer profitability that  Visa, Inc. traditionally has compiled. However, staff from this organization  said that this report is no longer being made publicly available.
We discussed issues relevant to this report with various organizations,  including representatives of 13 U.S. credit card issuers and card networks,  2 trade associations, 4 academics, 4 federal bank agencies, 4 national  consumer interest groups, 2 broker dealer analysts that study credit card  issuers for large investors, and a commercial credit-rating agency. We also  obtained technical comments on a draft of this report from representatives  of the issuers that supplied data for this study.
section_title: Consumer Bankruptcies Have Risen Along with Debt
paragraphs: Consumer bankruptcies have increased significantly over the past 25 years.  As shown in figure 21 below, consumer bankruptcy filings rose from about  287,000 in 1980 to more than 2 million as of December 31, 2005, about a 609  percent increase over the last 25 years.
The expansion of consumers’ overall indebtedness is one of the  explanations cited for the significant increase in bankruptcy filings. As  shown in figure 22, consumers’ use of debt has expanded over the last 25  years, increasing more than 720 percent from about $1.4 trillion in 1980 to  about $11.5 trillion in 2005.
Some researchers have been commenting on the rise in overall  indebtedness as a contributor to the rise in bankruptcies for some time. For  example, in a 1997 congressional testimony, a Congressional Budget Office  official noted that the increase in consumer bankruptcy filings and the  increase in household indebtedness appeared to be correlated. Also, an  academic paper that summarized existing literature on bankruptcy found  that some consumer bankruptcies were either directly or indirectly caused  by heavy consumer indebtedness, specifically pointing to the high  correlation between consumer bankruptcies and consumer debt-to-income  ratios.
Beyond total debt, some researchers and others argue that the rise in  bankruptcies also was related to the rise in credit debt, in particular. As  shown in figure 23, the amount of credit card debt reported also has risen  from $237 billion to about $802 billion—a 238 percent increase between  1990 and 2005.
subsections: section_title: Increased Access to Credit Cards by Lower-income Households Raised Concerns
paragraphs: Rather than total credit card debt alone, some researchers argued that  growth in credit card use and indebtedness by lower-income households  has contributed to the rise in bankruptcies. In the survey of consumer  finances conducted every 3 years, the Federal Reserve reports on the use  and indebtedness on credit cards by households overall and also by income  percentiles. As shown in figure 24 below, the latest Federal Reserve survey  results indicated the greatest increase of families reporting credit card debt  occurred among those in the lowest 20 percent of household income  between 1998 and 2001.
In the last 15 years, credit card companies have greatly expanded the  marketing of credit cards, including to households with lower incomes  than previously had been offered cards. An effort by credit card issuers to  expand its customer base in an increasingly competitive market  dramatically increased credit card solicitations. According to one study,  more than half of credit cards held by consumers are the result of receiving  mail solicitations. According to another academic research paper, credit  card issuers have increased the number of mail solicitations they send to  consumers by more than five times since 1990, from 1.1 billion to 5.23  billion in 2004, or a little over 47 solicitations per household. The research  paper also found that wealthier families receive the highest number of  solicitations but that low-income families were more likely to open them.   As shown in figure 25 above, the Federal Reserve’s survey results indicated  that the number of lower income households with credit cards has also  grown the most during 1998 to 2001, reflecting issuers’ willingness to grant  greater access to credit cards to such households than in the past.
section_title: Levels of Financial Distress Have Remained Stable among Households
paragraphs: The ability of households to make the payments on their debt appeared to  be keeping pace with their incomes as their total household debt burden  levels—which measure their payments required on their debts as  percentage of household incomes—have remained relatively constant  since the 1980s. As shown below in figure 25, Federal Reserve statistics  show that the aggregate debt burden ratio for U.S. households has  generally fluctuated between 10.77 percent to 13.89 percent between 1990  to 2005, which are similar to the levels for this ratio that were observed  during the 1980s. Also shown in figure 25 are the Federal Reserve’s  statistics on the household financial obligations ratio, which compares the  total payments that a household must make for mortgages, consumer debt,  auto leases, rent, homeowners insurance, and real estate taxes to its after- tax income. Although this ratio has risen from around 16 percent in 1980 to  over 18 percent in 2005—representing an approximately 13 percent  increase—Federal Reserve staff researchers indicated that it does not  necessarily indicate an increase in household financial stress because  much of this increase appeared to be the result of increased use of credit  cards for transactions and more households with cards.
In addition, credit card debt remains a small portion of overall household  debt, including those with the lowest income levels. As shown in table 2,  credit card balances as a percentage of total household debt actually have  been declining since the 1990s.
Board of Governors of the Federal Reserve System, Report to the Congress on Practices of  the Consumer Credit Industry in Soliciting and Extending Credit and their Effects on  Consumer Debt and Insolvency (Washington, D.C.: June 2006).
Also, as shown in table 3, median credit card balances for the lowest- income households has remained stable from 1998 through 2004.
As shown in figure 26 below, the number of households in the twentieth  percentile of income or less that reportedly were in financial distress has  remained relatively stable.
As shown in figure 26 above, more lower-income households generally  reported being in financial distress than did other households in most of  the other higher-income groups. In addition, the lowest-income households  in the aggregate generally did not exhibit greater levels of distress over the  last 20 years, as the proportion of households that reported distress was  higher in the 1990s than in 2004.
section_title: Some Researchers Find Other Factors May Trigger Consumer Bankruptcies and that Credit Cards Role Varied
paragraphs: Some academics, consumer advocacy groups, and others have indicated  that the rise in consumer bankruptcy filings has occurred because the  normal life events that reduce incomes or increase expenses for  households have more serious effects today. Events that can reduce  household incomes include job losses, pay cuts, or conversion of full-time  positions to part-time work. Medical emergencies can result in increased  household expenses and debts. Divorces can both reduce income and  increase expenses. One researcher explained that, while households have  faced the same kinds of risks for generations, the likelihood of these types  of life events occurring has increased. This researcher’s studies noted that  the likelihood of job loss or financial distress arising from medical  problems and the risk of divorce have all increased. Furthermore, more  households send all adults into the workforce, and, while this increases  their income, it also doubles their total risk exposure, which increases their  likelihood of having to file for bankruptcy. According to this researcher,  about 94 percent of families who filed for bankruptcy would qualify as  middle class.
Although many of the people who file for bankruptcy have considerable  credit card debt, those researchers that asserted that life events were the  primary explanation for filings noted that the role played by credit cards  varied. According to one of these researchers, individuals who have filed  for bankruptcy with outstanding credit card debt could be classified into  three groups:  Those who had built up household debts, including substantial credit  card balances, but filed for bankruptcy after experiencing a life event  that adversely affected their expenses or incomes such that they could  not meet their obligations.
Those who experienced a life event that adversely affected their  expenses or incomes, and increased their usage of credit cards to avoid  falling behind on other secured debt payments (such as mortgage debt),  but who ultimately failed to recover and filed for bankruptcy.
Those with very little credit card debt who filed for bankruptcy when  they could no longer make payments on their secured debt. This  represented the smallest category of people filing for bankruptcy.
section_title: Factors Contributing to the Profitability of Credit Card Issuers
paragraphs: Various factors help to explain why banks that focus on credit card lending  generally have higher profitability than other lenders. The major source of  income for credit card issuers comes from interest they earn from their  cardholders who carry balances—that is, do not payoff the entire  outstanding balance when due. One factor that contributes to the high  profitability of credit card operations is that the average interest rates  charged on credit cards are generally higher than rates charged on other  types of lending. Rates charged on credit cards are generally the highest  because they are extensions of credit that are not secured by any collateral  from the borrower. Unlike credit cards, most other types of consumer  lending involve the extension of a fixed amount of credit under fixed terms  of repayment (i.e., the borrower must repay an established amount of  principal, plus interest each month) and are collateralized—such as loans  for cars, under which the lender can repossess the car in the event the  borrower does not make the scheduled loan payments. Similarly, mortgage  loans that allow borrowers to purchase homes are secured by the  underlying house. Loans with collateral and fixed repayment terms pose  less risk of loss, and thus lenders can charge less interest on such loans. In  contrast, credit card loans, which are unsecured, available to large and  heterogeneous populations, and can be repaid on flexible terms at the  cardholders’ convenience, present greater risks and have commensurately  higher interest rates.
As shown in figure 27, data from the Federal Reserve shows that average  interest rates charged on credit cards were generally higher than interest  rates charged on car loans and personal loans. Similarly, average interest  rates charged on corporate loans are also generally lower than credit cards,  with the best business customers often paying the prime rate, which  averaged 6.19 percent during 2005.
Moreover, many card issuers have increasingly begun setting the interest  rates they charge their cardholders using variable rates that change as a  specified market index rate, such as the prime rate, changes. This allows  credit card issuers’ interest revenues to rise as their cost of funding rises  during times when market interest rates are increasing. Of the most  popular cards issued by the largest card issuers between 2004 and 2005 that  we analyzed, more than 90 percent had variable rates that changed  according to an index rate. For example, the rate that the cardholder would  pay on these large issuer cards was determined by adding between 6 and 8  percent to the current prime rate, with a new rate being calculated monthly.
As a result of the higher interest charges assessed on cards and variable  rate pricing, banks that focus on credit card lending had the highest net  interest margin compared with other types of lenders. The net interest  income of a bank is the difference between what it has earned on its  interest-bearing assets, including the balances on credit cards it has issued  and the amounts loaned out as part of any other lending activities, and its  interest expenses. To compare across banks, analysts calculate net interest  margins, which express each banks’ net interest income as a percentage of  interest-bearing assets. The Federal Deposit Insurance Corporation (FDIC)  aggregates data for a group of all federally insured banks that focus on  credit card lending, which it defines as those with more than 50 percent of  managed assets engaged in credit card operations; in 2005, FDIC identified  33 banks with at least this much credit card lending activity. As shown in  figure 28, the net interest margin of all credit card banks, which averaged  more than 8 percent, was about two to three times as high as other  consumer and mortgage lending activities in 2005. Five of the six largest  issuers reported to us that their average net interest margin in 2005 was  even higher, at 9 percent.
subsections: section_title: Credit Card Operations Also Have Higher Rates of Loan Losses and Operating Expenses
paragraphs: Although profitable, credit card operations generally experience higher  charge-off rates and operating expenses than those of other types of  lending. Because these loans are generally unsecured, meaning the  borrower will not generally immediately lose an asset—such as a car or  house—if payments are not made, borrowers may be more likely to cease  making payments on their credit cards if they become financially distressed  than they would for other types of credit. As a result, the rate of losses that  credit card issuers experience on credit cards is higher than that incurred  on other types of credit. Under bank regulatory accounting practices,  banks must write off the principal balance outstanding on any loan when it  is determined that the bank is unlikely to collect on the debt. For credit  cards, this means that banks must deduct, as a loan loss from their income,  the amount of balance outstanding on any credit card accounts for which  either no payments have been made within the last 180 days or the bank  has received notice that the cardholder has filed for bankruptcy. This  procedure is called charging the debt off. Card issuers have much higher  charge-off rates compared to other consumer lending businesses as shown  in figure 29.
The largest credit card issuers also reported similarly high charge-off rates  for their credit card operations. As shown in figure 30, five of the top six  credit card issuers that we obtained data from reported that their average  charge-off rate was higher than 5.5 percent between 2003 and 2005, well  above other consumer lenders’ average net charge-off rate of 1.44 percent.
Credit card issuers also incur higher operating expenses compared with  other consumer lenders. Operating expense is another one of the largest  cost items for card issuers and, according to a credit card industry research  firm, accounts for approximately 37 percent of total expenses in 2005. The  operating expenses of a credit card issuer include staffing and the  information technology costs that are incurred to maintain cardholders’  accounts. Operating expense as a proportion of total assets for credit card  lending is higher because offering credit cards often involves various  activities that other lending activities do not. For example, issuers often  incur significant expenses in postage and other marketing costs as part of  soliciting new customers. In addition, some credit cards now provide  rewards and loyalty programs that allow cardholders to earn rewards such  as free airline tickets, discounts on merchandise, or cash back on their  accounts, which are not generally expenses associated with other types of  lending. Credit card operating expense burden also may be higher because  issuers must service a large number of relatively small accounts. For  example, the six large card issuers that we surveyed reported that they  each had an average of 30 million credit card accounts, the average  outstanding balance on these accounts was about $2,500, and 48 percent of  accounts did not revolve balances in 2005.
As a result, the average operating expense, as a percentage of total assets  for banks, that focus on credit card lending averaged over 9 percent in  2005, as shown in figure 31, which was well above the 3.44 percent average  for other consumer lenders. The largest issuers operating expenses may  not be as high as all banks that focus on credit card lending because their  larger operations give them some cost advantages from economies of scale.  For example, they may be able to pay lower postage rates by being able to  segregate the mailings of account statements to their cardholders by zip  code, thus qualifying for bulk-rate discounts.
Another reason that the banks that issue credit cards are more profitable  than other types of lenders is that they earn greater percentage of revenues  from noninterest sources, including fees, than lenders that focus more on  other types of consumer lending. As shown in figure 32, FDIC data  indicates that the ratio of noninterest revenues to assets—an indicator of  noninterest income generated from outstanding credit loans—is about 10  percent for the banks that focus on credit card lending, compared with less  than 2.8 percent for other lenders.
section_title: Effect of Penalty Interest and Fees on Credit Card Issuer Profitability
paragraphs: Although penalty interest and fees apparently have increased, their effect  on issuer profitability may not be as great as other factors. For example,  while more cardholders appeared to be paying default rates of interest on  their cards, issuers have not been experiencing greater profitability from  interest revenues. According to our analysis of FDIC Quarterly Banking  Profile data, the revenues that credit card issuers earn from interest  generally have been stable over the last 18 years. As shown in figure 33, net  interest margin for all banks that focused on credit card lending has ranged  between 7.4 percent and 9.6 percent since 1987. Similarly, according to the  data that five of the top six issuers provided to us, their net interest margins  have been relatively stable between 2003 and 2005, ranging from 9.2  percent to 9.6 percent during this period.
These data suggest that increases in penalty interest assessments could be  offsetting decreases in interest revenues from other cardholders. During  the last few years, card issuers have competed vigorously for market share.  In doing so, they frequently have offered cards to new cardholders that  feature low interest rates—including zero percent for temporary  introductory periods, usually 8 months—either for purchases or sometimes  for balances transferred from other cards. The extent to which cardholders  now are paying such rates is not known, but the six largest issuers reported  to us that the proportion of their cardholders paying interest rates below 5  percent—which could be cardholders enjoying temporarily low  introductory rates—represented about 7 percent of their cardholders  between 2003 and 2005. To the extent that card issuers have been receiving  lower interest as the result of these marketing efforts, such declines could  be masking the effect of increasing amounts of penalty interest on their  overall interest revenues.
Although revenues from penalty fees have grown, their effect on overall  issuer profitability is less than the effect of income from interest or other  factors. For example, we obtained information from a Federal Reserve  Bank researcher with data from one of the credit card industry surveys that  illustrated that the issuers’ cost of funds may be a more significant factor  for their profitability lately. Banks generally obtain the funds they use to  lend to others through their operations from various sources, such as  checking or savings deposits, income on other investments, or borrowing  from other banks or creditors. The average rate of interest they pay on  these funding sources represents their cost of funds. As shown in table 4  below, the total cost of funds (for $100 in credit card balances outstanding)  for the credit card banks included in this survey declined from $8.98 in 1990  to a low of $2.00 in 2004—a decrease of 78 percent. Because card issuers’  net interest income generally represents a much higher percentage of  revenues than does income from penalty fees, its impact on issuers’ overall  profitability is greater; thus the reduction in the cost of funds likely  contributed significantly to the general rise in credit card banks’  profitability over this time.
Although card issuer revenues from penalty fees have been increasing  since the 1980s, they remain a small portion of overall revenues. As shown  in table 4 above, our analysis of the card issuer data obtained from the  Federal Reserve indicated that the amount of revenues that issuers  collected from penalty fees for every $100 in credit card balances  outstanding climbed from 69 cents to $1.40 between 1990 and 2004—an  increase of 103 percent. During this same period, net interest income  collected per $100 in card balances outstanding grew from $7.44 to  $10.45—an increase of about 41 percent. However, the relative size of each  of these two sources of income indicates that interest income is between 7  to 8 times more important to issuer revenues than penalty fee income is in  2004. Furthermore, during this same time, collections of annual fees from  cardholders declined from $1.25 to 42 cents per every $100 in card  balances—which means that the total of annual and penalty fees in 2004 is  about the same as in 1990 and that this decline may also be offsetting the  increased revenues from penalty fees.
section_title: Comments from the Federal Reserve Board
section_title: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to those named above, Cody Goebel, Assistant Director; Jon  Altshul; Rachel DeMarcus; Kate Magdelena Gonzalez; Christine Houle;  Christine Kuduk; Marc Molino; Akiko Ohnuma; Carl Ramirez; Omyra  Ramsingh; Barbara Roesmann; Kathryn Supinski; Richard Vagnoni; Anita  Visser; and Monica Wolford made key contributions to this report.