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Study: How Would Credit Card Reform Affect Low-Income Borrowers?

Angela K. Littwan of Harvard Law School has recently published a paper detailing the results of a study she conducted on the use of credit among low-income individuals.

Specifically, she sought to determine how restrictions on credit card lending would affect low-income borrowers' ability to get and use credit.

Her findings are intriguing.

Background: Why Study Credit Cards?

In 1978, the Supreme Court ruled that credit card issuers must adhere to the interest rate limits of the state in which the issuer is based, regardless of the laws in the cardholder's state. The ruling led several states to repeal interest rate caps to attract the business of credit card issuers - effectively, they'd be able to charge their cardholders as much as they wanted.

Then, in 2005, Congress passed new bankruptcy legislation that made discharging credit card debt more difficult for bankruptcy filers. Credit card companies spent hundreds of millions of dollars lobbying for these changes.

So basically, credit card issuers based in states with no interest rate caps can charge astronomical interest rates without much risk, since bankruptcy filers are less likely to be able to discharge their debt than before. This state of affairs seems to benefit credit card companies more than consumers. But the situation is more complex than that.

According to Littwan, traditional thinking holds that credit card restrictions and reforms (including usury caps, changes to the Truth in Lending Act and regulation of penalty fees) would actually harm card users. Why? Because of the "substitution effect."

Substituting One Credit Source for Another

Many experts apparently believe that, if credit cards were made less accessible to low-income borrowers, these borrowers would simply borrower more from other credit sources, including rent-to-own stores, payday lenders, pawn shops and more.

In many cases, such "alternative" or "fringe" sources of credit have higher interest rates and/or less favorable terms than credit cards, so borrowing more from them would, in theory, cost low-income consumers more money. For this theory to be accurate, Littwan declares, the various types of credit must be interchangeable and credit cards must not be the least desirable type of credit available.

But, according to Littwan's study, these two conditions don't hold true, suggesting that the substitution effect is less prominent than once believed. In fact, Littwan's research suggests that low-income borrowers could greatly benefit from credit card reform and/or restriction.

Credit Card Usage: "Tempted to Spend"

One of the most interesting findings of Littwan's study is the reported effect of credit card usage on spending habits of the subjects of the study. Littwan refers to previous studies that have found that credit cards often act as spending triggers - that is, when people see a credit card logo or know that a vendor accepts credit cards, they are likely to spend more money than they would have otherwise.

Littwan's subjects confirmed these findings, noting that they found themselves "tempted to spend" money when they knew they had a credit card available.

This probably doesn't surprise many people - the potential of getting something now and not having to pay for it until later can seem like a fantastic deal. But this same feature was why the subjects ultimately rated credit cards as one of the least desirable forms of credit - including pawn shops and rent-to-own stores.

Ultimately, Littwan's subjects gave credit cards low ratings because they didn't fully understand the terms of their loans when they made their original purchases. Littwan even goes so far as to suggest that credit card companies encourage an incomplete understanding of borrowing terms, because many issuers:

  • List the "minimum payment" more prominently on a credit card bill than the total amount due;
  • Name an introductory or "teaser" interest rate that adjusts after a certain period of time; and
  • Offer cards with terms and conditions that cover several pages in small font, discouraging users to read them thoroughly.

Littwan found that her subjects tended to go through a specific debt cycle when using credit cards:

  1. User gets a credit card (common reasons included emergency use, purchasing power, improvement of credit score, and curiosity).
  2. User experiences "temptation," makes purchases with card and pays less than full balance.
  3. User can no longer meet minimum payments and/or issuer refuses to raise credit limit further.

After the cycle is completed, most users focus on paying off their debt - which can grow enormously, and drive many to financial ruin. Littwan noted that several of the subjects asked for advice about filing bankruptcy during interviews for her research, even though she is not a bankruptcy lawyer.

And, because of the "temptation to spend" that accompanied credit card use for many borrowers, Littwan concluded that the substitution effect is not as prominent as once believed. After all, other credit sources (like pawn shops) provide very clear terms for borrowers, and come with an upfront cost (like a valued personal item) in exchange for a fixed loan.

Credit Cards: Too Unmanageable for Many Borrowers

The issue of "manageability" or "transparency" was rated by Littwan's subjects as the single biggest reason why credit cards were an unappealing source of credit.

In her conclusion, Littwan suggests improving and/or expanding credit card payment options so that borrowers have a better chance of understanding what they're getting into when they sign up for a new card, and are less likely to engage in behavior that can lead to serious debt down the road.

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