What is Happening to Your Credit?

To credit-card companies, it's not sufficient that customers pay their bills on time every month; they must also avoid a daunting array of borrowing habits that lenders deem risky. Like borrowing. Katie Groves, 42, learned this firsthand when the annual interest rate on her Chase Visa bill jumped to 29.99%—from the previous 12%. Although she had never missed a payment and owed only $500, she was told that her rate had increased because Chase had checked her credit report.

Most consumers are unaware that the banks constantly monitor all their borrowing behavior. Even if you just get too close to your borrowing limit (a figure you probably don't know) on your cards and mortgages, as Groves did, you can trigger what the industry calls universal default.
But ending universal default is only the start of sweeping changes to the lightly regulated, $160 billion credit-card industry that are being demanded by consumers and lawmakers alike. Both Hillary Clinton and Barack Obama are campaigning for credit-card reform. On Feb. 7, Representatives Carolyn Maloney and Barney Frank introduced a credit-card bill of rights that would make it harder for issuers to add fees and hike rates. Senator Carl Levin is also sponsoring a bill that would cap rate increases, rein in fees and require clearer disclosures of all costs.
The industry has reacted. Chase will join Citibank, which has ceased raising rates for customers on the basis of negative information in their credit reports. "There has never been such a spotlight on the industry," says Curtis Arnold, founder of CardRatings.com, which offers card tips. "It's historic."

The added interest and late fees that typically pile up when more consumers are late to pay or exceed their credit limit—thus triggering a higher rate—are feeding a consumer backlash that is gaining strength. In 2007, 11,427 people filed complaints with the Office of the Comptroller of the Currency, which oversees bank-issued cards—a 13% increase over 2006.
And last summer, when the Federal Reserve opened its website for public comments on its proposal that lenders give 45-day notice before jacking up rates, more than 2,500 consumers wrote in, including Lee Davis, who emailed, "It's a little late … credit card shenanigans have already cost me my future."

Our card habits are finally taking a toll. With more than a billion cards in our wallets, we floated some $937 billion in outstanding credit-card debt as of last November, according to the Federal Reserve. The average card-holding household has $9,659 in credit card debt, up from $2,966 in 1990. Seduced by 0% interest rates on balances transferred from other cards and blanketed with "convenience checks" that let us pay off other bills while card debt mounts, it is more tempting than ever to say yes. But whereas even a year ago, folks could tap their home equity to pay off credit card bills, declining home values have cut off that safety valve for many consumers. The result: a recent uptick in customer defaults. Meanwhile industry profits have risen from $27.4 billion in 2003 to $40.7 billion in 2007, according to RK Hammer.

Those profits have been achieved by applying mathematical formulas to decide who gets credit, how much, and at what rate. And by jacking up fees and interest rates for being late, overspending, or overborrowing. The convenience user, one who pays off her balance every month, is a loser. "The credit card industry doesn't really want you to pay off your debt," says Adam J. Levitin, a law professor at Georgetown University and expert in credit card regulatory and competition issues. "It's like a sweat box. They want you in there as long as possible."
Now, with politicians angry with the bankers over the subprime fiasco, the heat is rising on the industry's credit-card segment. One of the strongest proposed changes is Levin's provision to limit interest rate increases to no more than seven percentage points above the initial rate. "Too many card issuers engage in very, very severe abuses and outrageous practices. It’s indefensible," says Levin, who arrived at seven, because it is about 50% above many cards' initial interest rate of around 14%.

That could have helped avert Janet Hard's nightmare. The 42-year-old nurse from Freeland, Mich., says Discover raised the rate on her card from 7.9% in 2000 to 24.4% in February 2007, a period when she was charging her family of four's dentist bills to the card since they have no dental insurance. "When I look at the money that we have paid to Discover during just the last two years, I feel sick. Of the $5,618 made in payments to Discover, $3478.39 went to interest," Hard testified at a Senate hearing in December. "My husband and I feel as though we've been robbed," she added. Discover defends its rate increases on the basis that Hard was too close to her credit limit and late on payments to other credit issuers. That made her a riskier borrower, in the company's analysis.

The reason the card industry is free to raise prices on existing customers at any time and for any reason is tied to deregulation, which began in banking in the 1970s and effectively eliminated caps both on interest and fees. Thanks to mergers and consolidation, the top six card issuers—Bank of America, JPMorgan Chase, Citigroup, American Express, Capital One and Discover—now float about 75% of all outstanding credit-card debt, according to The Nilson Report. Consolidation allows competitors to be less competitive: from 1995 to 2005 the average late fee soared 162% from $12.83 to $33.64, according to CardTrak.com. Fees now account for 39% of issuers' revenue, up from 28% in 2000 (interest accounts for the rest), according to card advisor RK Hammer. The industry is so buoyant that transaction-giant Visa is planning an IPO this spring that could raise more than $10 billion in capital.

Although the industry continues to defend its "risk-based pricing", which it says has made cards more generally available, the voluntary changes from Chase and Citibank (which eliminated its universal default clause in 2007) show a new willingness to curb some of the more controversial practices. "They are kowtowing to political pressure," says Frank Braden, an equity analyst at Standard & Poors. Adds Levin, "They take it very seriously. I think they are very nervous."
And while the stereotype of a chronic debtor is of someone who is simply careless about spending money and paying bills on time, this is rarely the case. "Delinquency and default are nearly always due to loss of job or a 'life event' such as health problems (and medical bills), death or divorce," wrote analyst Chris Brendler of Stifel Nicolaus in a January report. Today's unemployment rate has yet to cause alarm, but it's the X factor that could determine how much worse credit-card defaults may get as recession looms.

Ruth Owens, 57, understands this first hand. She was living on social security disability when Discover Bank sued her for breach of contract for failing to pay $5,564 in fees and interest on a $1,900 debt. In 2004, a Cleveland, Ohio municipal judge not only barred Discover from collecting any more money from Owens, but scolded Discover for its "unreasonable, unconscionable and unjust business practice."

The verdict is still out, however, on whether even the proposed changes will curb our addiction to plastic. One banker said that a byproduct of a recession is that people charge more and don't pay it off, increasing their balances. Another is that it gives a bank that is ready for recession the opportunity to win share from the unprepared. Those might offset whatever pain the prospect of more regulation will bring.