The UK Cards Association’s response to recent press coverage on credit card interest rates
Average credit card APRs vs Base rate
Base rate is at an extraordinarily low level not previously seen in three hundred years and there is criticism that the average credit card APR (as calculated by the Bank of England) has recently been edging upwards. The average credit card APR is, in fact, itself at a relatively low level historically. The following chart shows the relationship between base rate and credit card interest rates over time using Bank of England data.
There are a number of factors that help explain what we see in the above chart:
- Credit card companies face a number of running costs that do not exist with other forms of lending such as mortgages or personal loans. The cost of borrowing money to finance cardholders’ balances – which will be more closely aligned with wholesale market rates than base rate anyway – generally accounts for only a proportion of a credit card issuers’ costs. Other costs such as authorising and processing transactions, posting out statements, issuing cards, handling customer queries, preventing fraud and covering the cost of fraud losses, covering the cost of bad debt, meeting the costs of section 75 cover for consumers, and delivering innovation (such as chip & PIN or contactless card payments) may be rising while base rates are falling. Base rate and wholesale rate changes need to have a substantial effect on card issuers’ total costs to justify a change in the interest rate charged to customers.
- Lenders have increasingly moved towards risk-based pricing where rates are tailored to the individual rather than granting the same rate to all customers. This is an inherently fairer means of reflecting the individual risk associated with a customer and eliminating the cross-subsidy that would otherwise occur, and serves to reduce financial exclusion. Unsurprisingly lenders will typically be assessing risk as being higher now than before the credit crunch.
- Changes in credit card rates are expensive for credit card issuers to implement. By law, rate changes have to be advertised and systems have to be altered. Point-of-sale literature is obliged to show interest rates, with an inevitably high cost of replacement
The problem with APRs for credit cards
It is important to note that a credit card APR is not an interest rate. If a customer pays off their balance in full – which the latest figures show relates to some 61% of all cardholders – they do not pay any interest at all and the APR is irrelevant. This is the clearest example where the effective rate incurred by the cardholder bears no relation to the rate advertised at the onset of the agreement and demonstrates the artificiality of the advertised rate.
Legislation requires that the APR reflects the total charge for credit so it takes account of factors beyond the interest rate, such as other non-interest costs (most notably annual fees). For a revolving credit product where the amount borrowed and the term of the borrowing are unknown, there is also a need to make a set of assumptions on how the card is used.
The assumptions used are based on an artificial and most unlikely borrowing behaviour i.e. borrowing up to the credit limit on day one, then repaid over one year in twelve equal installments, and with no further expenditure. The combination of these factors can impact the credit card’s advertised APR significantly and will seldom reflect the experience of any customer of any particular credit card. (You may be aware that we have been speaking to your officials regarding the type of evidence that we might provide to improve understanding in this area where we hope to submit some results soon).
Unfortunately the assumptions currently used can result in some cards, particularly those designed for the sub-prime or premium markets, having what appear to be very high APRs when the actual interest rate may, in fact, be quite competitive. The illustration below shows the affect of the APR calculation for three different types of card:
This analysis illustrates the perverse effect that the card with the lowest interest rate (Card C) ends up having the highest APR. It is worth noting that Card C has a minimum credit limit of £15,000 and if this had been used for the APR calculation (as it would have been pre-2006) the APR would be 15.6%. Card B’s APR is heavily influenced by the fact that legislation dictates that the £250 limit has to be assumed instead of the £1,500 used for other cards, meaning you are not comparing like with like.
So there are two key issues which affect credit card APRs and where the effects are difficult for customers to understand. In cases where the interest rate is the same for two cards but where one has a fee, the APR will always be higher than for the product with a fee. Secondly, the relationship between the amount of any fee and the assumed credit limit is also crucial. It is particularly difficult to explain why the assumed limit might be different.
APRs are prescribed as a one-size-fits-all means of comparing credit products, but they do not work well for credit cards which offer a wide range of limits and charges. These shortcomings were clearly highlighted to the then-DTI when re-drafting the APR calculation as part of the last review of the Consumer Credit Act. The method will change again when the Consumer Credit Directive is implemented in the UK in 2011, when the assumed credit limit will be reduced. This will result in an overnight increase in APRs for any credit card with an annual fee, despite the product and interest rate not changing.
In the past the industry suggested removing fees from the calculation, to make the APR more comparable, and to show all fees explicitly in the Summary Box. Whilst this is still not a perfect solution it would have reduced some of the problems that we see. Unfortunately this was not taken forward by Government, despite our view that this would be much clearer and useful for consumers.