What an interest rate increase will cost cardholders

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When interest rates finally start rising -- as soon as next spring -- Americans will pay as much as  $7.6 billion more annually on their credit cards, based on an analysis of industry records and Federal Reserve projections.

"I don't think consumers realize what a good deal they've had for so long," said Brian Riley, research director at the analysis firm CEB TowerGroup.

The Fed controls a key short-term rate on which most card rates are based. That federal funds rate has been at an historic low since 2008, when the Fed rapidly cut interest rates to stimulate the economy during the recession. Since then, fixed-rate cards have virtually vanished, and the industry switched to variable rates tied to the prime rate, an index that moves in step with the federal funds rate. That means the APRs on existing balances will go up when rates swing higher.

The Federal Reserve's rate-setting committee expects the federal funds rate to start rising in 2015, gaining a full percentage point over the span of a year. The corresponding increase in APRs would put the average interest rate for people who carry a balance at nearly 14 percent.

Since enactment of the Credit CARD Act of 2009 , cardholders have been protected from rate increases on their existing balance, with a few exceptions. One of law's exceptions: Variable-rate credit cards may change their rates automatically if they are pegged to a market index -- such as the prime rate . So when interest rates rise, APRs will go up on existing balances, as well as on new purchases.

The typical bite will be a manageable-sounding $80 a year for the average cardholder who carries a balance, but the added expenses will be higher for those with larger balances and tougher on people already stretching their budgets.

"There's going to be a little bit of interest rate shock," said Todd Mark, vice president of education at the Consumer Credit Counseling Service of Greater Dallas.

"What took five years to pay back goes maybe to six -- it's clearly detrimental to the consumer," said Robert Falk, CEO of Purdue Federal Credit Union in West Lafayette, Ind., one of the few financial institutions that still offers fixed-rate credit cards.     

Rating the impact
"This APR will vary with the market based on the prime rate," says a Citi card contract, echoing language found in most other agreements. Variable rate cards take the prime as a benchmark and add a set amount. "If the prime rate increases, it will cause the APR to increase." The prime moves in step with the federal funds rate.

Variable APRs may change as frequently as once a month, card agreements say, which means any time the Fed votes to increase the federal funds rate, that change will quickly be passed along to consumers as higher credit card rates.

U.S. credit card balances total $763 billion, according to an analysis by TransUnion. A 1 percentage point rise in rates will mean as much as $7.63 billion a year in extra interest costs. With about 158 million cardholders in the U.S, that would suggest a per-person bite of $48 a year.

But not every cardholder regularly carries a balance. The average credit card balance is about $8,200 on a card that usually carries a balance. That means the cost of the extra interest will be more like $80 a year, shouldered by people who carry balances.

About 9 million people have card balances of more than $20,000, TransUnion said. Of them, nearly 1 million face balances of more than $50,000 -- meaning as much as $500 a year more in interest costs, just to carry the same debt load.

"For consumers who have stretched themselves, it may throw them back into financial frailty," Mark said.

Where rates are going
The expected rise in rates is linked to the gradually improving health of the economy. When the rate-setting Federal Open Market Committee met under Janet Yellen as Fed chair for the first time March 18 and 19, it reaffirmed expectations of a rate increase in 2015 . In a press conference after the meeting, Yellen indicated that increases could begin about six months after the conclusion of the Fed's asset purchase program, which will wrap up this fall at its current pace. That makes the first hike possible in spring of 2015, subject to continued improvement in jobs and economic activity.

Most members on the rate-setting committee expect a half-point hike next year, as measured by the federal funds rate. That will be part of a full 1 percentage point increase through 2016, the majority expects. Sometime beyond that, as the economy hits its stride, the Fed projects rates would eventually rise a total of 4 percentage points.

The committee said it will consider starting the hikes "a considerable time" after wrapping up its asset purchase program, subject to inflation reaching a long-run target rate of 2 percent annually. However, inflation is running at an annual rate of about 1.6 percent currently, and Yellen said inflation responds only gradually to economic stimulus measures.

People with other variable-rate debt, such as adjustable mortgages or revolving home equity loans, will face higher costs for those payments as well. Although the housing bust took the steam out of revolving home-equity loans, there are still about 18 million of the loans outstanding, with an average balance of nearly $30,000, according to the Federal Reserve Bank of New York.

How interest costs play out
Rising rates will mean it takes longer to pay back a given credit card balance, experts said. As the payback period stretches out and the cost of interest climbs, a given debt burden will become harder to repay -- meaning it carries higher risk for the lender. Consequently, terms of credit will tighten up, and people who are used to low-rate offers could be cut off from cheap credit.

One prediction is that cheap balance-transfer deals will get less cheap -- to the discomfort of people who are accustomed to parking balances at 0 percent in return for a fee. Riley, the research director at CEB TowerGroup, said he expects balance transfer options will tighten as rates begin to climb.

"There are two ways to tweak it -- shorten the term of the introductory rate or maybe not carry over at 0 percent," he said.

In fact, interest-free periods have already shown signs of shrinking. In CreditCards.com's 2014 balance transfer survey , the longest 0-percent introductory period available was 18 months, compared to a 21-month maximum from several issuers in 2012. And while the typical balance transfer fee remains around 3 percent, some issuers are bumping up the fee after an introductory period -- meaning higher costs if you move another balance on the card after the initial transfer.

Tips for battling rising rates
The good news is that there's probably at least a year before the interest bite begins on monthly balances.

"Even when rates begin to rise, we anticipate it will be a very slow and gradual process," said Keith Leggett, vice president and senior economist for the American Bankers Association. When they do, it will mean the economy is healthier, so rising incomes should help make higher financing costs more affordable, he said.

However, he notes, "Financial circumstances are not evenly distributed across the population -- there are always people who are going to have issues."

With many households treading close to the financial edge, budget counselors recommend using the time to whittle down balances and expenses, and doing what you can to lock in lower rates now. If the squeeze causes missed payments, the penalty interest rates levied by card companies will dwarf any increase the Fed has in mind. Most cards impose rates between 23 percent and 30 percent for making more than one late payment on a credit card balance.

According to a survey by the Consumer Federation of America completed Feb. 2, households have less financial cushion than they did in 2010. Sixty-four percent of respondents said they have an adequate rainy day fund to cope with emergencies such as doctor bills or car repairs, down from 71 percent four years earlier.  

"One-third of households are not saving at all ... They're also the group most likely to be carrying burdensome debt," said Stephen Brobeck, executive director of the consumer federation.

Switching to a fixed-rate card is not an easy solution. An analysis of 1,600 credit card agreements filed with federal regulators shows that fewer than 100 offer fixed rates on general purpose cards, and most are from credit unions with limited fields of membership. Purdue Federal in West Lafayette, Ind., for example, has 63,000 members, most of them with ties to Purdue University.

Fixed-rate redux?
CEO Falk expects that Purdue's fixed-rate card will come into fashion when big issuers start raising their APRs. Some issuers will move a balance onto a fixed-rate repayment plan as part of a negotiated arrangement, debt counselors said.

But for the majority of households that do not have access to fixed-rate cards, Falk suggests moving revolving debt to a term loan. A "fully amortizing" term loan, which is paid off within a set number of monthly installments, carries a repayment discipline that credit cards lack.

"Every month you're paying down some principal, guaranteed," he said.

No easy fixes
Counselors offered no magic bullet for clearing away debt, just the difficult work of cutting discretionary expenses such as travel, entertainment and eating out, while reviewing harder-to-cut utilities and other monthly bills.

"People can normally start making changes to their budget in 30 to 60 days," said Johnson at Clearpoint. However, he expects most families that need to overhaul their budget will get serious about it only when the squeeze hits home.

"A lot of people don't think of how the card is a variable rate -- it's been set for such a long period," he said. "It's not that they're not paying attention -- people just have lives."

Earlier story: Variable interest rate cards replace fixed-rate cards

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Personal Finance , Credit and Debt

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