Wednesday, December 17, 2008

Freakonomics:The Fiendish Genius of Credit-Card Minimum Payments

From the Freakonomics blog:

New research finds that credit-card holders pay down their debts more slowly when their statements suggest a minimum monthly installment.
I don't think anyone is shocked by that. The credit card industry has long had bare minimum payments, enough to keep their consumers solvent. The interesting part of the study they cite is that even for customers that tend to pay more than the minimum payment, the existence of a stated minimum payment acts as a kind of "anchor" on what they actually pay. That is, if you were inclined to pay $100 on your balance this month, and then you see the statement and it only carries a minimum payment of $48, you're likely to pay far less than the $100 you intended and then rationalize that you are still paying more than the minimum.

Say you’re a credit card company. You make money every time one of your card holders carries a balance at the end of the month, because you charge interest on that debt. A lot of interest. The longer your card holder carries debt, the more money you make.

But if that debt tips out of control, and the card holder defaults, you lose everything.

So you want to find a middle road, a strategy that will keep your card holder’s debt manageable, but that will stretch out repayment as far into the future as possible, maximizing your profits.

I thought I remembered some changes to the minimum payment structure as a part of the bankruptcy overhaul from a few years ago, and I was right.

In the past, credit card companies required customers to pay an average of just 2 percent of their total credit card balance, which meant constant debt for many consumers. The 2 percent minimum payment only covered interest and other fees, so it often could take a lifetime to pay off the principal balance.

By the end of 2005, new banking guidelines went into effect in an effort to save consumers from themselves. Banking regulators issued the guidelines that pressured credit card companies to boost minimum payments so debts would be paid off in a reasonable time. For many banks, that has translated into new rules requiring monthly minimums to cover interest, any fees or extra charges and at least 1 percent of the principal amount.

Some overhaul... now instead of just paying interest and fees, you have to pay interest and fees, plus 1% of your principal.

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