Tom didn’t set out to be financially delinquent—in fact, when he signed up for his first credit card as a freshman in college, he thought he was being quite responsible by building up a credit history.

By senior year, Tom had racked up several thousand dollars in credit card debt as he charged school-related expenses and other incidentals. Tom wasn’t worried about his mounting bills, as he would soon be entering the workforce full-time.

According to an April 2009 report from SallieMae, 84 percent of college undergrads have at least one credit card. Half of the students polled had four or more cards.
According to an April 2009 report from SallieMae, 84 percent of college undergrads have at least one credit card. Half of the students polled had four or more cards.

Tom did eventually find a job after a few months of searching, during which he used credit to float by. He intended to pay down his debt, but by that time he’d become accustomed to living slightly beyond his means, filling the gap with credit and making the minimum payment each month. His debt escalated, especially as his credit card rates steadily and stealthily increased from 8 percent to 15 percent for no discernable reason.

When the economy worsened and Tom lost his job, he knew he was in trouble. The credit card company raised rates on his large existing balance to 24 percent after a missed payment. Now broke and unemployed, Tom wonders how he got to the point where bankruptcy is an attractive option.

Tom’s is a common tale in the credit-saturated U.S. society, where “enjoy it now, pay for it later,” is the favorite message of marketers. As more and more Americans slide toward financial ruin, consumer advocacy groups that for years have spoken out against abuses by the credit card companies have finally been heard. On May 22, President Obama signed the Credit Accountability, Responsibility, and Disclosure (CARD) Act of 2009 into law, which will limit or change the way credit card companies do business starting in February 2010.

Will the bill make a difference to consumers or the economy? Kelly Haws says the effect of the legislation will be significant. Haws, assistant professor of marketing at Texas A&M University’s Mays Business School, has conducted several studies on consumer use of credit. “Consumers might actually change their spending behaviors as a direct consequence of this legislation,” said Haws. “Even if it has only a minor effect, it could be huge when it comes to how people are managing their personal finances.”

More disclosure = more responsible spending?

As the U.S. economy continues to languish, people are spending less, and so like many other industries, credit card companies have been making less. This situation led some creditors to come up with creative ways to boost revenues, such as “any time, any reason” rate hikes or hidden fees (Americans pay about $15 billion each year in credit card penalty fees). The CARD Act bans certain rate increases and unfair fee traps, as well as mandating more transparency between lender and borrower. When the bill takes effect in a few months, credit card companies will be required to notify consumers of rate changes 45 days in advance of the change. Also, companies will be required to display the consequences of credit decisions to consumers in periodic statements, such as how long it will take to pay off an existing balance with interest if the consumer pays only the minimum balance.

Haws says that this kind of stipulation is potentially positive, but that many consumers don’t take the time to understand financial statements. Benefits of that component of the act may be limited if consumers disregard notices from their creditors that seem too complex.

According to a study Haws conducted, people will modify their spending behavior when given greater information about the real costs involved with using credit. However, her study involved subjects in a controlled setting, a very different environment from the one experienced by most credit card holders on a daily basis. “In the real world, there are a lot of distractions that can influence those actions,” said Haws.

Even without full comprehension of the statements they’ll receive, consumers will benefit from their new protection under the law, which will ban credit card companies from increasing rates retroactively without cause. Companies will also be severely restricted from retroactively increase rates due to late payment.

Slow down, Junior

One area of the new law both Haws and colleague Don Fraser agree will be impactful is the age restriction. “This is one of the most important dimensions of the legislation,” said Fraser, Hugh Roy Cullen Chair in Business and associate head of the department of finance at Mays.

The CARD Act will prevent credit card companies from targeting potential customers under 21. Those under 21 that want a credit card must have a co-signer on the account, or show proof of independent means.

Currently anyone over 18 can get a credit card—and many do. According to an April 2009 report from SallieMae called “How Undergraduate Students Use Credit Cards,” (download a copy here) 84 percent of college undergrads have at least one credit card. Half of the students polled had four or more cards. The study also noted that undergraduates are carrying record-high credit card balances, with the average (mean) balance of $3,173. More than 20 percent of undergrads reported credit card balances between $3,000 and $7,000.

In the past, credit card companies were allowed to market aggressively on college campuses, incentivizing their offers with promotional gifts from tee shirts to iPods. “Removing the ease of accessibility to that market could really be transformational,” says Haws. College years are formative, making it an opportune time for credit card companies to lock in a customer for life on the debt merry-go-round, as young people often lack the knowledge or analytical skills to use credit wisely. Haws notes that some college campuses already ban credit card sales reps on their premises as a protection to students. Getting parents on board as potential cosigners is beneficial, too, as past research suggests that this could help prevent debt from accumulating during college years. “Studies show that the more parents are involved, the more responsible the student’s use of the credit card is,” she said. (( Palmer, T.S., Pinto, M.B., and Parente, D.H., College Students’ Credit Card Debt and the Role of Parental Involvement: Implications for Public Policy. Journal of Public Policy and Marketing, 20(1): 105-113 (2001). ))

Drawing the legislative line

Though the CARD Act passed through the Senate with a vote of 90-5, showing overwhelming support for regulation of credit card practices, some economists wonder if it was the right thing to do. After all, if a product is bad, shouldn’t consumers stop buying it? According to a 2009 Nilson report, 78 percent of American households have at least one credit card. Clearly, consumers are still purchasing these services. The free market philosophy that the U.S. economy is built upon argues that the consumer demand will regulate the market eventually on its own, without interference from the government.

  • Consumer protection for those under 21
  • Bans unfair rate increases, including retroactive rate increases
  • Prevents unfair fee traps
  • Plain sight /plain language disclosures
  • Accountability

“My opinion is that the legislation was badly needed, as there were numerous examples of abuses by credit card lenders. It would have been better if these changes had been made some years earlier,” said Fraser, commenting that though some consumers (likely those with the best credit practices, who pay off their balance each month) will may see an increase in rates and fees, overall consumers will be better off as a result of the legislation.

Haws agrees that the credit card reform is positive, as the consumers that are often most affected by predatory practices by credit companies are the ones who can least afford to pay, such as those with excessive debt from medical or other unforeseen expenses. “This will provide protection for consumers that are already hurting,” said Haws.

Other detractors of the bill hypothesize that this increase in regulation will lead to a tightening of the credit market, which will hamper economic recovery. “From a macro economic perspective, I would expect that the legislations will reduce the amount of consumer spending and thus increase the amount of consumer saving,” said Fraser. “In the short run, this will tend to dampen any economic recovery, but probably not to a large degree. In the long run, however, it will encourage saving, something that will be a net benefit for the economy.”

Will the legislation force an overhaul of credit card practices as companies struggle to stay profitable? What will the future of the credit industry look like? “Obviously, to the extent that the new legislation is successful in limiting or reducing the abusive practices, the credit card issuers will have to seek alternative revenue sources from their credit card customers,” said Fraser. “This is especially relevant today as the bank issuers of these credit cards are often in serious financial difficulty and in some cases on the verge of failure. They cannot tolerate significant reductions in their revenue streams.” Fraser suggested that credit card lenders may increase their average interest rates, screen out certain less profitable borrowers who may not use their cards often or who pay in full at the end of the payment period, or deny cards to those with low FICO scores, in an attempt to stay profitable.

Will rewards programs and no annual fee cards disappear under the new model as some have predicted? “I’ll believe it when I see it,” says Haws. “It’s such a competitive market that it’s unlikely they will do away with all of these programs.”