A piece in the Globe and Mail this morning on a platform item for the NDP brings to mind the quote from Shakespeare. The NDP would peg maximum credit card rates at 5%+Prime. At first blush this does seem to be such a bad idea. About a third of Canadians cannot pay off their credit card debt at the end of the month. But let's look closer.
In order to set the stage, the credit card companies such as Visa and MasterCard make money on the transaction fees paid by merchants. The loan portion of the transaction--that is when you don't pay the full balance at the end of the month is financed by a bank that sponsors the credit card.
Interest is rent for money and reflects both the cost of money and the risk that the borrower will not repay. Banks are not in the business of funding risk. But credit card divisions of banks do just that. They know, as a matter of statistics, that a significant number of their borrowers will not pay. So, the high rates of 19%+ reflects a rate that the credit worthy borrowers pay to subsidize those who do not pay. The fact that the return on equity by banks who advance this debt is not egregious, you can say that the system works well as it is. If you want to be frugal then credit cards cost you little beyond the annual fee that you pay your bank for issuing the card. If the rate subsidy was not correct and banks made a higher than normal return on equity then others would enter the field and drive down the rates through competition. Conversely if the rate subsidy was not correct and the banks made a lower than normal return on equity they would simply get out of the business.
My guess is that a prime + 5% cap on credit card fees would have a significantly adverse effect for the consumer and on the economy. I believe that this kind of return would not result in a reasonable return on invested capital to the bank. The subsidy would be too low. Since Visa and MasterCard does not want to get out of the business--merchants pay fees whether the customer pays or not--the banks would have to adjust its lending pool to reflect the right amount of subsidy. It would mean that a large number of customers would be dropped off the pool. This would, in turn, reflect a decrease of demand and stores would suffer. For an economy that is driven, for most part, by consumption this is not the right answer.
Economic evidence is that a significant increase in credit card rates does not affect demand much. So long as the minimum payment remains affordable the fact that the debt will not be paid off for 30 years does not seem to bother most consumers. There is rarely any "equity" in the loan--that is any real decrease in the principal. Increasing the minimum payment will have a significant effect on consumers. This is like requiring homeowners to come up with a larger down payment when buying a home. If the credit card debt were amortized over 10 years there would be an incentive on the part of the consumer to save. Those who could not pay the minimum payment would either buy for cash or postpone purchases until they had saved enough. Those who chose the minimum payment would have an affordable payment plan that would give them some equity in the debt in the near term. It would make a nation of savers out of Canadians rather than a nation of deadbeats.
But, you say, such a plan would still have a negative effect on the economy. It would mean less purchases. True, that that decrease would be offset by savings that would, in turn, have a positive effect on the economy.
Bernie.
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