Developments in the pricing of credit card services

Federal Reserve Bulletin, Sept, 1992 by Glenn B. Canner, Charles A. Luckett, Wayne C. Cook, Mark A. Peirce

Information theory suggests that revolvers would be much more likely than convenience users to be sensitive to the level of the interest rate assessed on credit cards, although convenience users may be quite sensitive to the amount of the annual fee and the length of the interest-free grace period. Results of a 1986 survey of cardholders by Payment Systems, Inc. (PSI), support these implications of information theory.(21) The survey found that revolvers were more likely than convenience users to read credit card solicitation materials, and a larger proportion of revolvers said that they would apply for a card with a lower rate if it were offered.

The PSI survey also found that the larger the outstanding balance a revolver carried, the more likely the cardholder would be to apply for a lowerrate card.(22) In this context it is important to note that, although the amount of credit card debt owed by cardholders who revolve varies substantially, a large fraction owe relatively small amounts. The 1989 Survey of Consumer Finances, for example, revealed that, among cardholders with debt, 32 percent owed less than $500 at the time of the survey, and an additional 18 percent owed between $500 and $1,000 (table 5). Thus, a significant number of those who use credit cards as a borrowing device may have balances small enough to render the interest rate a secondary consideration in deciding which cards to hold.

Practical Considerations

The foregoing analysis implies that one reason credit card rates have not varied greatly over time is that a large proportion of cardholders are likely to be relatively insensitive to the finance rates charged on their cards. Interest rates are largely irrelevant, of course, for convenience users. But even for many who revolve balances, the dollar amounts at stake may be fairly small. For example, for a family owing the median amount of credit card debt in 1989--roughly $1,250 (table 5)--a 3 percentage point drop in the rate would reduce the annual interest charge by less than $40. It is questionable whether a $40 annual saving would be enough to induce a cardholder to switch from a card that has been providing satisfactory service or attractive enhancements.

There are other reasons cardholders might be relatively insensitive to interest rates. In many instances, the credit limit is lower on a newly issued card. Also, there is no guarantee that the rate on the new card will stay low, or that the new card issuer's performance on such key matters as avoiding or rapidly rectifying billing errors will measure up to the previous card issuer's record. Factoring in other disutilities of switching cards, such as the nuisance of filling out applications and comparing the nonrate features of different cards, the inertia of many cardholders with respect to rate differences does not seem unreasonable. (23)

Finally, some cardholders, including a portion who carry high levels of credit card debt from month to month, may be willing but unable to switch to credit card plans that offer reduced rates because they cannot qualify for these plans. Poor debt repayment records or high levels of debt relative to income make these potential switchers relatively unattractive high-risk prospects to issuers of lower-rate cards.