Credit card penalty rates can top 30 percent; how to avoid them
Survey shows penalty APRs can double, triple normal card rates
By Jeremy M. Simon | Published: January 27, 2010
Think it costs a lot to borrow on your credit card now? Make a late payment and your interest rate could jump to more than 30 percent.
Default interest rates -- the penalty rates charged when borrowers violate the terms of their card agreements -- can be two to three times higher than regular rates on your credit card. The current national average default rate stands at 27.88 percent and the mean default rate is 28.99 percent, according to data compiled by CreditCards.com. And while credit card reforms are tightening the rules on how quickly issuers can implement them, default rates are still an indignity that should be avoided at all costs.
"It's starting to be almost unbelievable how high some of the credit card companies are going with their rates," says Lauren Bowne, staff attorney with advocacy group Consumers Union.
How the survey worked, what it showed
To calculate the national average, CreditCards.com surveyed penalty annual percentage rates (APRs) listed for approximately 90 online credit card offers from a variety of issuers, ranging from major banks to subprime lenders. Not all lenders charge a default rate, and those that did not were not included in the average. In instances where the card offered a default APR range, we chose the highest APR in that range.
What we found was that for cardholders with a typical default rate, even one mistake can be costly. At today's average penalty rate, someone who borrowed $5,000 on a credit card and consistently paid $150 per month at could wind up forking over $9,726 to pay off that debt. That's $3,468 more than would be required at the current average national APR for new card offers, which CreditCards.com's Weekly Rate Report showed to be 13.16 percent.
But not all default rates are created equal. At the high end, HSBC charges a penalty rate of 31.99 percent. Why so much? "Details of programs are proprietary, but I can tell you that HSBC strives to keep its products competitively priced and default APRs are only one aspect of pricing," says HSBC spokeswoman Kate P. Durham. "We believe we fairly set our prices based on economic, market and other factors in order to achieve an adequate return for our shareholders while providing customers with products and services that meet their credit needs."
On the other side of the spectrum, Navy Federal Credit Union charges a penalty rate of 17.90 percent, the lowest among the cards surveyed. The credit union introduced its default rate in May 2009 to account for credit risk, and since then has not altered its default pricing. As for why its default rate is comparatively low, the Navy Federal Credit Union points to laws governing lending by credit unions. "The Federal Credit Union Act caps credit union APRs at 15 percent; however, our regulator (National Credit Union Administration) is permitted to periodically review this rate every 18 months to determine if it should be higher. NCUA is currently allowing credit unions to charge no more than 18 percent APR," says Thomas Greek, Navy Federal's assistant vice president of credit cards, in an e-mail.
Some issuers that cater to cardholders with bad credit -- known in the business as subprime customers -- don't charge any penalty APRs. New Millennium Bank says its secured credit cardholders may default, "but we would like to give customers the opportunity at a second chance at building their credit, instead of taking advantage of the customer with inflation or penalty rates when an occasional payment is missed," says senior vice president Chip Sisler. That doesn't mean cardholders who slip up get a pass, however, with New Millennium charging $20 each for late payments and exceeding your credit limit. Subprime issuer First Premier likewise doesn't charge its cardholders penalty rates, opting for penalty fees instead.
The changing face of penalty rates
These rates are nothing new. Many cardholders have been dealing with penalty APRs since they first appeared in the late 1990s. Since then, they've become much more widespread -- and often more costly for borrowers. Default rates averaged 22.75 percent in 1998, according to an annual survey by consumer advocacy group Consumer Action, and have fluctuated over the years before reaching 25.28 percent in the spring of 2009.
However, under a new law that takes effect in February 2010, banks will find it tougher to raise rates when cardholders make mistakes. The consumer-friendly Credit CARD Act says that cardholders will need to be a full 60 days late with a payment before they can be penalized by an issuer. Additionally, the CARD Act requires banks to review any rate increases at least every six months, but it doesn't require a rate decrease by any specific amount. That could change, however. The Federal Reserve, however, hasn't yet written its final rules regarding this portion of the Act, since it doesn't take effect until August.
How to avoid default rates
Borrowers need to avoid the errors that activate default pricing. Luckily, these default rate triggers are easily identifiable. "Year after year, we know what they are," says Linda Sherry, national priorities director for Consumer Action in Washington, D.C.
- Late payment. "The biggest trigger is a late payment," Bowne says. A credit card payment may be considered late if it isn't received by the due date and time, so make sure to be prompt when sending your money either by regular mail or electronically.
- Going over the limit. Nearing the limit on your credit line can impact your credit utilization
-- the ratio of credit available to credit in use -- and lower your credit score. Exceeding the limit, meanwhile, can result in penalty APR pricing. Both mistakes make borrowing more costly.
- Paying with insufficient funds. Just as merchants don't appreciate being paid with a check that later bounces, banks frown on payment from an account with insufficient funds. Not surprisingly, banks penalize cardholders who make that mistake.
As banks struggle to make money in a challenging economy and regulatory environment, it's a bad time for cardholders to slip up. "By talking to consumers, right now credit card issuers are looking for every excuse to jack up APRs," says Consumer Union's Bowne.
See related: Credit card interest rates hit highest level since 2007, A comprehensive guide to the Credit CARD Act of 2009, How your credit utilization ratio is calculated, Creative new fees escape CARD Act rules, surprise consumers
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