Credit Cards: Increased Complexity in Rates and Fees Heightens	 
Need for More Effective Disclosures to Consumers (12-SEP-06,	 
GAO-06-929).							 
                                                                 
With credit card penalty rates and fees now common, the Federal  
Reserve has begun efforts to revise disclosures to better inform 
consumers of these costs. Questions have also been raised about  
the relationship among penalty charges, consumer bankruptcies,	 
and issuer profits. GAO examined (1) how card fees and other	 
practices have evolved and how cardholders have been affected,	 
(2) how effectively these pricing practices are disclosed to	 
cardholders, (3) the extent to which penalty charges contribute  
to cardholder bankruptcies, and (4) card issuers' revenues and	 
profitability. Among other things, GAO analyzed disclosures from 
popular cards; obtained data on rates and fees paid on cardholder
accounts from 6 large issuers; employed a usability consultant to
analyze and test disclosures; interviewed a sample of consumers  
selected to represent a range of education and income levels; and
analyzed academic and regulatory studies on bankruptcy and card  
issuer revenues.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-929 					        
    ACCNO:   A60724						        
  TITLE:     Credit Cards: Increased Complexity in Rates and Fees     
Heightens Need for More Effective Disclosures to Consumers	 
     DATE:   09/12/2006 
  SUBJECT:   Bankruptcy 					 
	     Consumer education 				 
	     Consumer protection				 
	     Credit						 
	     Credit sales					 
	     Data collection					 
	     Debt						 
	     Federal regulations				 
	     Fees						 
	     Fines (penalties)					 
	     Information disclosure				 
	     Interest rates					 
	     Late payments					 
	     Lending institutions				 
	     Policy evaluation					 
	     Statistical data					 
	     Surveys						 

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GAO-06-929

     

     * Report to the Ranking Minority Member, Permanent Subcommittee on
       Investigations, Committee on Homeland Security and Governmental
       Affairs, U.S. Senate
          * September 2006
     * CREDIT CARDS
          * Increased Complexity in Rates and Fees Heightens Need for More
            Effective Disclosures to Consumers
     * Contents
          * Results in Brief
          * Background
          * Credit Card Fees and Issuer Practices That Can Increase
            Cardholder Costs Have Expanded, but a Minority of Cardholders
            Appear to Be Affected
               * Issuers Have Developed More Complex Credit Card Pricing
                 Structures
                    * Multiple Interest Rates May Apply to a Single Account
                      and May Change Based on Market Fluctuations
                    * Credit Cards Increasingly Have Assessed Higher Penalty
                      Fees
                    * Cards Now Frequently Include a Range of Other Fees
               * Issuers Have Introduced Various Practices that Can
                 Significantly Affect Cardholder Costs
                    * Interest Rate Changes
                    * Payment Allocation Method
                    * Balance Computation Method
               * New Practices Appear to Affect a Minority of Cardholders
                    * Issuers Say Practices Benefit More Cardholders, but
                      Critics Say Some Practices Harm Consumers
                    * Most Active Accounts Are Assessed Lower Rates Than in
                      the Past
                    * Minority of Cardholders Appear to Be Affected by
                      Penalty Charges Assessed by the Largest U.S. Issuers
          * Weaknesses in Credit Card Disclosures Appear to Hinder Cardholder
            Understanding of Fees and Other Practices That Can Affect Their
            Costs
               * Mandatory Disclosure of Credit Card Terms and Conditions Is
                 the Primary Means Regulators Use for Ensuring Competitive
                 Credit Card Pricing
               * Credit Card Disclosures Typically Provided to Many Consumers
                 Have Various Weaknesses
                    * Disclosures Written at Too High a Level
                    * Poor Organization and Formatting
                    * Excessive Complexity and Volume of Information
               * Consumer Confusion Indicated That Disclosures Were Not
                 Communicating Credit Card Cost Information Clearly
               * Federal Reserve Effort to Revise Regulations Presents
                 Opportunity to Improve Disclosures
                    * Regulations and Guidance May Contribute to Weaknesses
                      in Current Disclosures
                    * Suggestions for Improving Disclosures Included
                      Obtaining Input from Consumers
          * Although Credit Card Penalty Fees and Interest Could Increase
            Indebtedness, the Extent to Which They Have Contributed to
            Bankruptcies Was Unclear
               * Researchers Cited Various Factors as Explanations for Rise
                 in Consumer Bankruptcies
                    * Increase in Household Indebtedness
                    * Other Explanations
               * The Extent to Which Credit Card Penalty Interest and Fees
                 Contribute to Consumer Bankruptcies Remains Controversial in
                 the Absence of Comprehensive Data
                    * Opinions on the Link between Credit Card Practices and
                      Bankruptcies Vary
                    * Penalty Interest and Fees Can Affect Cardholders'
                      Ability to Reduce Outstanding Balances
                    * In Some Court Cases, Cardholders Paid Significant
                      Amounts of Penalty Interest and Fees
                    * Data for Some Bankrupt Cardholders Shows Little in
                      Interest and Fees Owed, but Comprehensive Data Were Not
                      Available
          * Although Penalty Interest and Fees Likely Have Grown as a Share
            of Credit Card Revenues, Large Card Issuers' Profitability Has
            Been Stable
               * Publicly Disclosed Data on Revenues and Profits from Penalty
                 Interest and Fees Are Limited
               * Majority of Card Issuer Revenues Came from Interest Charges
               * Fees Represented the Remainder of Issuer Revenues
                    * Penalty Fees Had Increased
                    * Issuers Also Collect Revenues from Processing Merchant
                      Card Transactions
               * Large Credit Card Issuer Profitability Has Been Stable
          * Conclusions
          * Recommendation for Executive Action
          * Agency Comments and Our Evaluation
     * Objectives, Scope and Methodology
          * Methodology for Identifying the Evolution of Pricing Structures
          * Methodology for Assessing Effectiveness of Disclosures
          * Methodology for Determining How Penalty Charges Contribute to
            Bankruptcy
          * Methodology for Determining How Penalty Charges Contribute to
            Issuer Revenues
     * Consumer Bankruptcies Have Risen Along with Debt
          * Debt Levels Have Also Risen
          * Increased Access to Credit Cards by Lower-income Households
            Raised Concerns
          * Levels of Financial Distress Have Remained Stable among
            Households
          * Some Researchers Find Other Factors May Trigger Consumer
            Bankruptcies and that Credit Cards Role Varied
     * Factors Contributing to the Profitability of Credit Card Issuers
          * Credit Card Operations Also Have Higher Rates of Loan Losses and
            Operating Expenses
          * Effect of Penalty Interest and Fees on Credit Card Issuer
            Profitability
     * Comments from the Federal Reserve Board
     * GAO Contact and Staff Acknowledgments
     * PDF6-Ordering Information.pdf
          * Order by Mail or Phone

Report to the Ranking Minority Member, Permanent Subcommittee on
Investigations, Committee on Homeland Security and Governmental Affairs,
U.S. Senate

September 2006

CREDIT CARDS

Increased Complexity in Rates and Fees Heightens Need for More Effective
Disclosures to Consumers

Contents

Tables

Figures

September 12, 2006Letter

The Honorable Carl Levin Ranking Minority Member Permanent Subcommittee on
Investigations Committee on Homeland Security and Governmental Affairs
United States Senate

Dear Senator Levin:

Over the past 25 years, the prevalence and use of credit cards in the
United States has grown dramatically. Between 1980 and 2005, the amount
that U.S. consumers charged to their cards grew from an estimated $69
billion per year to more than $1.8 trillion, according to one firm that
analyzes the card industry.1 This firm also reports that the number of
U.S. credit cards issued to consumers now exceeds 691 million. The
increased use of credit cards has contributed to an expansion in household
debt, which grew from $59 billion in 1980 to roughly $830 billion by the
end of 2005.2 The Board of Governors of the Federal Reserve System
(Federal Reserve) estimates that in 2004, the average American household
owed about $2,200 in credit card debt, up from about $1,000 in 1992.3

Generally, a consumer's cost of using a credit card is determined by the
terms and conditions applicable to the card-such as the interest rate(s),
minimum payment amounts, and payment schedules, which are typically
presented in a written cardmember agreement-and how a consumer uses

a card.4 The Federal Reserve, under the Truth in Lending Act (TILA), is
responsible for creating and enforcing requirements relating to the
disclosure of terms and conditions of consumer credit, including those
applicable to credit cards.5 The regulation that implements TILA's
requirements is the Federal Reserve's Regulation Z.6 As credit card use
and debt have grown, representatives of consumer groups and issuers have
questioned the extent to which consumers understand their credit card
terms and conditions, including issuers' practices that-even if permitted
under applicable terms and conditions-could increase consumers' costs of
using credit cards. These practices include the application of fees or
relatively high penalty interest rates if cardholders pay late or exceed
credit limits. Issuers also can allocate customers' payments among
different components of their outstanding balances in ways that maximize
total interest charges. Although card issuers have argued that these
practices are appropriate because they compensate for the greater risks
posed by cardholders who make late payments or exhibit other risky
behaviors, consumer groups say that the fees and practices are harmful to
the financial condition of many cardholders and that card issuers use them
to generate profits.

You requested that we review a number of issues related to credit card
fees and practices, specifically of the largest issuers of credit cards in
the United States. This report discusses (1) how the interest, fees, and
other practices that affect the pricing structure of cards from the
largest U.S. issuers have evolved and cardholders' experiences under these
pricing structures in recent years; (2) how effectively the issuers
disclose the pricing structures of cards to their cardholders (3) whether
credit card debt and penalty interest and fees contribute to cardholder
bankruptcies; and (4) the extent to which penalty interest and fees
contribute to the revenues and profitability of issuers' credit card
operations.

To identify the pricing structures of cards-including their interest
rates, fees, and other practices-we analyzed the cardmember agreements, as
well as materials used by the six largest issuers as of December 31, 2004,
for 28 popular cards used to solicit new credit card customers from 2003
through 2005.7 To determine the extent to which these issuers' cardholders
were assessed interest and fees, we obtained data from each of the six
largest issuers about their cardholder accounts and their operations. To
protect each issuer's proprietary information, a third-party organization,
engaged by counsel to the issuers, aggregated these data and then provided
the results to us. Although the six largest issuers whose accounts were
included in this survey and whose cards we reviewed may include some
subprime accounts, we did not include information in this report relating
to cards offered by credit card issuers that engage primarily in subprime
lending.8 To assess the effectiveness of the disclosures that issuers
provide to cardholders in terms of their usability or readability, we
contracted with a consulting firm that specializes in assessing the
readability and usability of written and other materials to analyze a
representative selection of the largest issuers' cardmember agreements and
solicitation materials, including direct mail applications and letters,
used for opening an account (in total, the solicitation materials for four
cards and cardmember agreements for the same four cards).9 The consulting
firm compared these materials to recognized industry guidelines for
readability and presentation and conducted testing to assess how well
cardholders could use the materials to identify and understand information
about these credit cards. While the materials used for the readability and
usability assessments appeared to be typical of the large issuers'
disclosures, the results cannot be generalized to materials that were not
reviewed. We also conducted structured interviews to learn about the
card-using behavior and knowledge of various credit card terms and
conditions of 112 consumers recruited by a market research organization to
represent a range of adult income and education levels. However, our
sample of cardholders was too small to be statistically representative of
all cardholders, thus the results of our interviews cannot be generalized
to the population of all U.S. cardholders. We also reviewed comment
letters submitted to the Federal Reserve in response to its comprehensive
review of Regulation Z's open-end credit rules, including rules pertaining
to credit card disclosures.10 To determine the extent to which credit card
debt and penalty interest and fees contributed to cardholder bankruptcies,
we analyzed studies, reports, and bank regulatory data relating to credit
card debt and consumer bankruptcies, as well as information reported to us
as part of the data request to the six largest issuers. To determine the
extent to which penalty interest and fees contributes to card issuers'
revenues and profitability, we analyzed publicly available sources of
revenue and profitability data for card issuers, including information
included in reports filed with the Securities and Exchange Commission and
bank regulatory reports, in addition to information reported to us as part
of the data request to the six largest issuers.11 In addition, we spoke
with representatives of other U.S. banks that are large credit card
issuers, as well as representatives of consumer groups, industry
associations, academics, organizations that collect and analyze
information on the credit card industry, and federal banking regulators.
We also reviewed research reports and academic studies of the credit card
industry.

We conducted our work from June 2005 to September 2006 in Boston; Chicago;
Charlotte, North Carolina; New York City; San Francisco; Wilmington,
Delaware; and Washington, D.C., in accordance with generally accepted
government auditing standards. Appendix I describes the objectives, scope,
and methodology of our review in more detail.

Results in Brief

Since about 1990, the pricing structures of credit cards have evolved to
encompass a greater variety of interest rates and fees that can increase
cardholder's costs; however, cardholders generally are assessed lower
interest rates than those that prevailed in the past, and most have not
been assessed penalty fees. For many years after being introduced, credit
cards generally charged fixed single rates of interest of around 20
percent, had few fees, and were offered only to consumers with high credit
standing. After 1990, card issuers began to introduce cards with a greater
variety of interest rates and fees, and the amounts that cardholders can
be charged have been growing. For example, our analysis of 28 popular
cards and other information indicates that cardholders could be charged

o up to three different interest rates for different transactions, such as
one rate for purchases and another for cash advances, with rates for
purchases that ranged from about 8 percent to about 19 percent;

o penalty fees for certain cardholder actions, such as making a late
payment (an average of almost $34 in 2005, up from an average of about $13
in 1995) or exceeding a credit limit (an average of about $31 in 2005, up
from about $13 in 1995); and

o a higher interest rate-some charging over 30 percent-as a penalty for
exhibiting riskier behavior, such as paying late.

Although consumer groups and others have criticized these fees and other
practices, issuers point out that the costs to use a card can now vary
according to the risk posed by the cardholder, which allows issuers to
offer credit with lower costs to less-risky cardholders and credit to
consumers with lower credit standing, who likely would have not have
received a credit card in the past. Although cardholder costs can vary
significantly in this new environment, many cardholders now appear to have
cards with interest rates less than the 20 percent rate that most cards
charged prior to 1990. Data reported by the top six issuers indicate that,
in 2005, about 80 percent of their active U.S. accounts were assessed
interest rates of less than 20 percent-with more than 40 percent having
rates of 15 percent or less.12 Furthermore, almost half of the active
accounts paid little or no interest because the cardholder generally paid
the balance in full. The issuers also reported that, in 2005, 35 percent
of their active U.S. accounts were assessed late fees and 13 percent were
assessed over-limit fees.

Although credit card issuers are required to provide cardholders with
information aimed at facilitating informed use of credit and enhancing
consumers' ability to compare the costs and terms of credit, we found that
these disclosures have serious weaknesses that likely reduced consumers'
ability to understand the costs of using credit cards. Because the pricing
of credit cards, including interest rates and fees, is not generally
subject to federal regulation, the disclosures required under TILA and
Regulation Z are the primary means under federal law for protecting
consumers against inaccurate and unfair credit card practices.13 However,
the assessment by our usability consultant found that the disclosures in
the customer solicitation materials and cardmember agreements provided by
four of the largest credit card issuers were too complicated for many
consumers to understand. For example, although about half of adults in the
United States read at or below the eighth-grade level, most of the credit
card materials were written at a tenth- to twelfth-grade level. In
addition, the required disclosures often were poorly organized, burying
important information in text or scattering information about a single
topic in numerous places. The design of the disclosures often made them
hard to read, with large amounts of text in small, condensed typefaces and
poor, ineffective headings to distinguish important topics from the
surrounding text. Perhaps as a result of these weaknesses, the cardholders
tested by the consultant often had difficulty using these disclosures to
locate and understand key rates or terms applicable to the cards.
Similarly, our interviews with 112 cardholders indicated that many failed
to understand key terms or conditions that could affect their costs,
including when they would be charged for late payments or what actions
could cause issuers to raise rates. The disclosure materials that
consumers found so difficult to use resulted from issuers' attempts to
reduce regulatory and liability exposure by adhering to the formats and
language prescribed by federal law and regulations, which no longer suit
the complex features and terms of many cards. For example, current
disclosures require that less important terms, such as minimum finance
charge or balance computation method, be prominently disclosed, whereas
information that could more significantly affect consumers' costs, such as
the actions that could raise their interest rate, are not as prominently
disclosed. With the goal of improving credit card disclosures, the Federal
Reserve has begun obtaining public and industry input as part of a
comprehensive review of Regulation Z. Industry participants and others
have provided various suggestions to improve disclosures, such as placing
all key terms in one brief document and other details in a much longer
separate document, and both our work and that of others illustrated that
involving consultants and consumers can help develop disclosure materials
that are more likely to be effective. Federal Reserve staff told us that
they have begun to involve consumers in the preparation of potentially new
and revised disclosures. Nonetheless, Federal Reserve staff recognize the
challenge of presenting the variety of information that consumers may need
to understand the costs of their cards in a clear way, given the
complexity of credit card products and the different ways in which
consumers use credit cards.

Although paying penalty interest and fees can slow cardholders' attempts
to reduce their debt, the extent to which credit card penalty fees and
interest have contributed to consumer bankruptcies is unclear. The number
of consumers filing for bankruptcy has risen more than sixfold over the
past 25 years-a period when the nation's population grew by 29 percent-to
more than 2 million filings in 2005, but debate continues over the reasons
for this increase. Some researchers attribute the rise in bankruptcies to
the significant increase in household debt levels that also occurred over
this period, including the dramatic increase in outstanding credit card
debt. However, others have found that relatively steady household debt
burden ratios over the last 15 years indicate that the ability of
households to make payments on this expanded indebtedness has kept pace
with growth in their incomes. Similarly, the percentage of households that
appear to be in financial distress-those with debt payments that exceed 40
percent of their income-did not change much during this period, nor did
the proportion of lower-income households with credit card balances.
Because debt levels alone did not appear to clearly explain the rise in
bankruptcies, some researchers instead cited other explanations, such as a
general decline in the stigma associated with bankruptcies or the
increased costs of major life events-such as health problems or divorce-to
households that increasingly rely on two incomes. Although critics of the
credit card industry have cited the emergence of penalty interest rates
and growth in fees as leading to increased financial distress, no
comprehensive data exist to determine the extent to which these charges
contributed to consumer bankruptcies. Any penalty charges that cardholders
pay would consume funds that could have been used to repay principal, and
we obtained anecdotal information on a few court cases involving consumers
who incurred sizable penalty charges that contributed to their financial
distress. However, credit card issuers said that they have little
incentive to cause their customers to go bankrupt. The six largest issuers
reported to us that of their active accounts in 2005 pertaining to
cardholders who had filed for bankruptcy before their account became 6
months delinquent, about 10 percent of the outstanding balances on those
accounts represented unpaid interest and fees. However, issuers told us
that their data system and recordkeeping limitations prevented them from
providing us with data that would more completely illustrate a
relationship between penalty charges and bankruptcies, such as the amount
of penalty charges that bankrupt cardholders paid in the months prior to
filing for bankruptcy or the amount of penalty charges owed by cardholders
who went bankrupt after their accounts became more than 6 months
delinquent.

Although penalty interest and fees have likely increased as a portion of
issuer revenues, the largest issuers have not experienced greatly
increased profitability over the last 20 years. Determining the extent to
which penalty interest charges and fees contribute to issuers' revenues
and profits was difficult because issuers' regulatory filings and other
public sources do not include such detail. Using data from bank
regulators, industry analysts, and information reported by the five
largest issuers, we estimate that the majority-about 70 percent in recent
years-of issuer revenues came from interest charges, and the portion
attributable to penalty rates appears to have been growing. The remaining
issuer revenues came from penalty fees-which had generally grown and were
estimated to represent around 10 percent of total issuer revenues-as well
as fees that issuers receive for processing merchants' card transactions
and other sources. The profits of the largest credit-card-issuing banks,
which are generally the most profitable group of lenders, have generally
been stable over the last 7 years.

This report recommends that, as part of its effort to increase the
effectiveness of disclosure materials, the Federal Reserve should ensure
that such disclosures, including model forms and formatting requirements,
more clearly emphasize those terms that can significantly affect
cardholder costs, such as the actions that can cause default or other
penalty pricing rates to be imposed. We provided a draft of this report to
the Federal Reserve, the Office of the Comptroller of the Currency (OCC),
the Federal Deposit Insurance Corporation (FDIC), the Federal Trade
Commission, the National Credit Union Administration, and the Office of
Thrift Supervision for comment. In its written comments, the Federal
Reserve agreed that current credit card pricing structures have added to
the complexity of card disclosures and indicated that it is studying
alternatives for improving both the content and format of disclosures,
including involving consumer testing and design consultants.

Background

Credit card use has grown dramatically since the introduction of cards
more than 5 decades ago. Cards were first introduced in 1950, when Diners
Club established the first general-purpose charge card that allowed its
cardholders to purchase goods and services from many different merchants.
In the late 1950s, Bank of America began offering the first widely
available general purpose credit card, which, unlike a charge card that
requires the balance to be paid in full each month, allows a cardholder to
make purchases up to a credit limit and pay the balance off over time. To
increase the number of consumers carrying the card and to reach retailers
outside of Bank of America's area of operation, other banks were given the
opportunity to license Bank of America's credit card. As the network of
banks issuing these credit cards expanded internationally, administrative
operations were spun off into a separate entity that evolved into the Visa
network. In contrast to credit cards, debit cards result in funds being
withdrawn almost immediately from consumers' bank accounts (as if they had
a written a check instead). According to CardWeb.com, Inc., a firm that
collects and analyzes data relating to the credit card industry, the
number of times per month that credit or debit cards were used for
purchases or other transactions exceeded 2.3 billion in May 2003, the last
month for which the firm reported this data.

The number of credit cards in circulation and the extent to which they are
used has also grown dramatically. The range of goods and services that can
be purchased with credit cards has expanded, with cards now being used to
pay for groceries, health care, and federal and state income taxes. As
shown in figure 1, in 2005, consumers held more than 691 million credit
cards and the total value of transactions for which these cards were used
exceeded $1.8 trillion.

Figure 1: Credit Cards in Use and Charge Volume, 1980-2005

The largest issuers of credit cards in the United States are commercial
banks, including many of the largest banks in the country. More than 6,000
depository institutions issue credit cards, but, over the past decade, the
majority of accounts have become increasingly concentrated among a small
number of large issuers. Figure 2 shows the largest bank issuers of credit
cards by their total credit card balances outstanding as of December 31,
2004 (the most recent data available) and the proportion they represent of
the overall total of card balances outstanding.

Figure 2: The 10 Largest Credit Card Issuers by Credit Card Balances
Outstanding as of December 31, 2004

TILA is the primary federal law pertaining to the extension of consumer
credit. Congress passed TILA in 1968 to provide for meaningful disclosure
of credit terms in order to enable consumers to more easily compare the
various credit terms available in the marketplace, to avoid the uninformed
use of credit, and to protect themselves against inaccurate and unfair
credit billing and credit card practices. The regulation that implements
TILA's requirements is Regulation Z, which is administered by the Federal
Reserve.

Under Regulation Z, card issuers are required to disclose the terms and
conditions to potential and existing cardholders at various times. When
first marketing a card directly to prospective cardholders, written or
oral applications or solicitations to open credit card accounts must
generally disclose key information relevant to the costs of using the
card, including the applicable interest rate that will be assessed on any
outstanding balances and several key fees or other charges that may apply,
such as the
fee for making a late payment.14 In addition, issuers must provide
consumers with an initial disclosure statement, which is usually a
component of the issuer's cardmember agreement, before the first
transaction is made with a card. The cardmember agreement provides more
comprehensive information about a card's terms and conditions than would
be provided as part of the application or a solicitation letter.

In some cases, the laws of individual states also can affect card issuers'
operations. For example, although many credit card agreements permit
issuers to make unilateral changes to the agreement's terms and
conditions, some state laws require that consumers be given the right to
opt out of changes. However, as a result of the National Bank Act, and its
interpretation by the U.S. Supreme Court, the interest and fees charged by
a national bank on credit card accounts is subject only to the laws of the
state in which the bank is chartered, even if its lending activities occur
outside of its charter state.15 As a result, the largest banks have
located their credit card operations in states with laws seen as more
favorable for the issuer with respect to credit card lending.

Various federal agencies oversee credit card issuers. The Federal Reserve
has responsibility for overseeing issuers that are chartered as state
banks and are also members of the Federal Reserve System. Many card
issuers are chartered as national banks, which OCC supervises. Other
regulators of bank issuers are FDIC, which oversees state-chartered banks
with federally insured deposits that are not members of the Federal
Reserve System; the Office of Thrift Supervision, which oversees federally
chartered and state-chartered savings associations with federally insured
deposits; or the National Credit Union Administration, which oversees
federally-chartered and state-chartered credit unions whose member
accounts are federally insured. As part of their oversight, these
regulators review card issuers' compliance with TILA and ensure that an
institution's credit card operations do not pose a threat to the
institutions' safety and soundness. The Federal Trade Commission generally
has responsibility for enforcing TILA and other consumer protection laws
for credit card issuers that are not depository institutions.

Credit Card Fees and Issuer Practices That Can Increase Cardholder Costs
Have Expanded, but a Minority of Cardholders Appear to Be Affected

Prior to about 1990, card issuers offered credit cards that featured an
annual fee, a relatively high, fixed interest rate, and low penalty fees,
compared with average rates and fees assessed in 2005. Over the past 15
years, typical credit cards offered by the largest U.S. issuers evolved to
feature more complex pricing structures, including multiple interest rates
that vary with market fluctuations. The largest issuers also increased the
number, and in some cases substantially increased the amounts, of fees
assessed on cardholders for violations of the terms of their credit
agreement, such as making a late payment. Issuers said that these changes
have benefited a greater number of cardholders, whereas critics contended
that some practices unfairly increased cardholder costs. The largest six
issuers provided data indicating that most of their cardholders had
interest rates on their cards that were lower than the single fixed rates
that prevailed on cards prior to the 1990s and that a small proportion of
cardholders paid high penalty interest rates in 2005. In addition,
although most cardholders did not appear to be paying penalty fees, about
one-third of the accounts with these largest issuers paid at least one
late fee in 2005.

Issuers Have Developed More Complex Credit Card Pricing Structures

The interest rates, fees, and other practices that represent the pricing
structure for credit cards have become more complex since the early 1990s.
After first being introduced in the 1950s, for the next several decades,
credit cards commonly charged a single fixed interest rate around 20
percent-as the annual percentage rate (APR)-which covered most of an
issuer's expenses associated with card use.16 Issuers also charged
cardholders an annual fee, which was typically between $20 and $50
beginning in about 1980, according to a senior economist at the Federal
Reserve Board. Card issuers generally offered these credit cards only to
the most creditworthy U.S. consumers. According to a study of credit card
pricing done by a member of the staff of one of the Federal Reserve Banks,
few issuers in the late 1980s and early 1990s charged cardholders fees as
penalties if they made late payments or exceeded the credit limit set by
the issuer.17 Furthermore, these fees, when they were assessed, were
relatively small. For example, the Federal Reserve Bank staff member's
paper notes that the typical late fee charged on cards in the 1980s ranged
from $5 to $10.

Multiple Interest Rates May Apply to a Single Account and May Change Based
on Market Fluctuations

After generally charging just a single fixed interest rate before 1990,
the largest issuers now apply multiple interest rates to a single card
account balance and the level of these rates can vary depending on the
type of transaction in which a cardholder engages. To identify recent
pricing trends for credit cards, we analyzed the disclosures made to
prospective and existing cardholders for 28 popular credit cards offered
during 2003, 2004, and 2005 by the six largest issuers (based on credit
card balances outstanding at the end of 2004).18 At that time, these
issuers held almost 80 percent of consumer debt owed to credit card
issuers and as much as 61 percent of total U.S. credit card accounts. As a
result, our analysis of these 28 cards likely describes the card pricing
structure and terms that apply to the majority of U.S. cardholders.
However, our sample of cards did not include subprime cards, which
typically have higher cost structures to compensate for the higher risks
posed by subprime borrowers.

We found that all but one of these popular cards assessed up to three
different interest rates on a cardholder's balance. For example, cards
assessed separate rates on

o balances that resulted from the purchase or lease of goods and services,
such as food, clothing, and home appliances;

o balances that were transferred from another credit card, which
cardholders may do to consolidate balances across cards to take advantage
of lower interest rates; and

o balances that resulted from using the card to obtain cash, such as a
withdrawal from a bank automated teller machine.

In addition to having separate rates for different transactions, popular
credit cards increasingly have interest rates that vary periodically as
market interest rates change. Almost all of the cards we analyzed charged
variable rates, with the number of cards assessing these rates having
increased over the most recent 3-year period. More specifically, about 84
percent of cards we reviewed (16 of 19 cards) assessed a variable interest
rate in 2003, 91 percent (21 of 23 cards) in 2004, and 93 percent (25 of
27 cards) in 2005.19 Issuers typically determine these variable rates by
taking the prevailing level of a base rate, such as the prime rate, and
adding a fixed percentage amount.20 In addition, the issuers usually reset
the interest rates on a monthly basis.

Issuers appear to have assessed lower interest rates in recent years than
they did prior to about 1990. Issuer representatives noted that issuers
used to generally offer cards with a single rate of around 20 percent to
their cardholders, and the average credit card rates reported by the
Federal Reserve were generally around 18 percent between 1972 and 1990.
According to the survey of credit card plans, conducted every 6 months by
the Federal Reserve, more than 100 card issuers indicated that these
issuers charged interest rates between 12 and 15 percent on average from
2001 to 2005. For the 28 popular cards we reviewed, the average interest
rate that would be assessed for purchases was 12.3 percent in 2005, almost
6 percentage points lower than the average rates that prevailed until
about 1990. We found that the range of rates charged on these cards was
between about 8 and 19 percent in 2005. The average rate on these cards
climbed slightly during this period, having averaged about 11.5 percent in
2003 and about 12 percent in 2004, largely reflecting the general upward
movement in prime rates. Figure 3 shows the general decline in credit card
interest rates, as reported by the Federal Reserve, between about 1991 and
2005 compared with the prime rate over this time. As these data show,
credit card interest rates generally were stable regardless of the level
of market interest rates until around 1996, at which time changes in
credit card rates approximated changes in market interest rates. In
addition, the spread between the prime rate and credit card rates was
generally wider in the period before the 1980s than it has been since
1990, which indicates that since then cardholders are paying lower rates
in terms of other market rates.

Figure 3: Credit Card Interest Rates, 1972-2005

Recently, many issuers have attempted to obtain new customers by offering
low, even zero, introductory interest rates for limited periods. According
to an issuer representative and industry analyst we interviewed, low
introductory interest rates have been necessary to attract cardholders in
the current competitive environment where most consumers who qualify for a
credit card already have at least one. Of the 28 popular cards that we
analyzed, 7 cards (37 percent) offered prospective cardholders a low
introductory rate in 2003, but 20 (74 percent) did so in 2005-with most
rates set at zero for about 8 months. According to an analyst who studies
the credit card industry for large investors, approximately 25 percent of
all purchases are made with cards offering a zero percent interest rate.

Increased competition among issuers, which can be attributed to several
factors, likely caused the reductions in credit card interest rates. In
the early 1990s, new banks whose operations were solely focused on credit
cards entered the market, according to issuer representatives. Known as
monoline banks, issuer representatives told us these institutions competed
for cardholders by offering lower interest rates and rewards, and expanded
the availability of credit to a much larger segment of the population.
Also, in 1988, new requirements were implemented for credit card
disclosures that were intended to help consumers better compare pricing
information on credit cards. These new requirements mandated that card
issuers use a tabular format to provide information to consumers about
interest rates and some fees on solicitations and applications mailed to
consumers. According to issuers, consumer groups, and others, this format,
which is popularly known as the Schumer box, has helped to significantly
increase consumer awareness of credit card costs.21 According to a study
authored by a staff member of a Federal Reserve Bank, consumer awareness
of credit card interest rates has prompted more cardholders to transfer
card balances from one issuer to another, further increasing competition
among issuers.22 However, another study prepared by the Federal Reserve
Board also attributes declines in credit card interest rates to a sharp
drop in issuers' cost of funds, which is the price issuers pay other
lenders to obtain the funds that are then lent to cardholders.23 (We
discuss issuers' cost of funds later in this report.)

Our analysis of disclosures also found that the rates applicable to
balance transfers were generally the same as those assessed for purchases,
but the rates for cash advances were often higher. Of the popular cards
offered by the largest issuers, nearly all featured rates for balance
transfers that were substantially similar to their purchase rates, with
many also offering low introductory rates on balance transfers for about 8
months. However, the rates these cards assessed for obtaining a cash
advance were around 20 percent on average. Similarly to rates for
purchases, the rates for cash advances on most cards were also variable
rates that would change periodically with market interest rates.

Credit Cards Increasingly Have Assessed Higher Penalty Fees

Although featuring lower interest rates than in earlier decades, typical
cards today now include higher and more complex fees than they did in the
past for making late payments, exceeding credit limits, and processing
returned payments. One penalty fee, commonly included as part of credit
card terms, is the late fee, which issuers assess when they do not receive
at least the minimum required payment by the due date indicated in a
cardholder's monthly billing statement. As noted earlier, prior to 1990,
the level of late fees on cards generally ranged from $5 to $10. However,
late fees have risen significantly. According to data reported by
CardWeb.com, Inc., credit card late fees rose from an average of $12.83 in
1995 to $33.64 in 2005, an increase of over 160 percent. Adjusted for
inflation, these fees increased about 115 percent on average, from $15.61
in 1995 to $33.64 in 2005.24 Similarly, Consumer Action, a consumer
interest group that conducts an annual survey of credit card costs, found
late fees rose from an average of $12.53 in 1995 to $27.46 in 2005, a 119
percent increase (or 80 percent after adjusting for inflation).25 Figure 4
shows trends in average late fee assessments reported by these two groups.

Figure 4: Average Annual Late Fees Reported from Issuer Surveys, 1995-2005
(unadjusted for inflation)

Notes: Consumer Action data did not report values for 1996 and 1998.

CardWeb.com, Inc. data are for financial institutions with more than $100
million in outstanding receivables.

In addition to increased fees a cardholder may be charged per occurrence,
many cards created tiered pricing that depends on the balance held by the
cardholder.26 Between 2003 and 2005, all but 4 of the 28 popular cards
that we analyzed used a tiered fee structure. Generally, these cards
included three tiers, with the following range of fees for each tier:

o $15 to $19 on accounts with balances of $100 or $250;

o $25 to $29 on accounts with balances up to about $1,000; and

o $34 to $39 on accounts with balances of about $1,000 or more.

Tiered pricing can prevent issuers from assessing high fees to cardholders
with comparatively small balances. However, data from the Federal
Reserve's Survey of Consumer Finances, which is conducted every 3 years,
show that the median total household outstanding balance on U.S. credit
cards was about $2,200 in 2004 among those that carried balances. When we
calculated the late fees that would be assessed on holders of the 28 cards
if they had the entire median balance on one card, the average late fee
increased from $34 in 2003 to $37 in 2005, with 18 of the cards assessing
the highest fee of $39 in 2005.

Issuers also assess cardholders a penalty fee for exceeding the credit
limit set by the issuer. In general, issuers assess over-limit fees when a
cardholder exceeds the credit limit set by the card issuer. Similar to
late fees, over-limit fees also have been rising and increasingly involve
a tiered structure. According to data reported by CardWeb.com, Inc., the
average over-limit fees that issuers assessed increased 138 percent from
$12.95 in 1995 to $30.81 in 2005. Adjusted for inflation, average
over-limit fees reported by CardWeb.com increased from $15.77 in 1995 to
$30.81 in 2005, representing about a 95 percent increase.27 Similarly,
Consumer Action found a 114 percent increase in this period (or 76
percent, after adjusting for inflation). Figure 5 illustrates the trend in
average over-limit fees over the past 10 years from these two surveys.

Figure 5: Average Annual Over-limit fees Reported from Issuer Surveys,
1995-2005 (unadjusted for inflation)

Notes: Consumer Action did not report values for 1996 and 1998.

CardWeb.com, Inc. data are for financial institutions with more than $100
million in outstanding receivables.

The cards we analyzed also increasingly featured tiered structures for
over-limit fees, with 29 percent (5 of 17 cards) having such structures in
2003, and 53 percent (10 of 19 cards) in 2005. Most cards that featured
tiered over-limit fees assessed the highest fee on accounts with balances
greater than $1,000. But not all over-limit tiers were based on the amount
of the cardholder's outstanding balance. Some cards based the amount of
the over-limit fee on other indicators, such as the amount of the
cardholder's credit limit or card type. For the six largest issuers'
popular cards with over-limit fees, the average fee that would be assessed
on accounts that carried the median U.S. household credit card balance of
$2,200 rose from $32 in 2003 to $34 in 2005. Among cards that assessed
over-limit fees in 2005, most charged an amount between $35 and $39.

Not all of the 28 popular large-issuer cards included over-limit fees and
the prevalence of such fees may be declining. In 2003, 85 percent, or 17
of 20 cards, had such fees, but only 73 percent, or 19 of 26 cards, did in
2005. According to issuer representatives, they are increasingly
emphasizing competitive strategies that seek to increase the amount of
spending that their existing cardholders do on their cards as a way to
generate revenue. This could explain a movement away from assessing
over-limit fees, which likely discourage cardholders who are near their
credit limit from spending.

Cards also varied in when an over-limit fee would be assessed. For
example, our analysis of the 28 popular large-issuer cards showed that, of
the 22 cards that assessed over-limit fees, about two-thirds (14 of 22)
would assess an over-limit fee if the cardholder's balance exceeded the
credit limit within a billing cycle, whereas the other cards (8 of 22)
would assess the fee only if a cardholder's balance exceeded the limit at
the end of the billing cycle. In addition, within the overall limit, some
of the cards had separate credit limits on the card for how much a
cardholder could obtain in cash or transfer from other cards or creditors,
before similarly triggering an over-limit fee.

Finally, issuers typically assess fees on cardholders for submitting a
payment that is not honored by the issuer or the cardholder's paying bank.
Returned payments can occur when cardholders submit a personal check that
is written for an amount greater than the amount in their checking account
or submit payments that cannot be processed. In our analysis of 28 popular
cards offered by the six largest issuers, we found the average fee charged
for such returned payments remained steady between 2003 and 2005 at about
$30.

Cards Now Frequently Include a Range of Other Fees

Since 1990, issuers have appended more fees to credit cards. In addition
to penalties for the cardholder actions discussed above, the 28 popular
cards now often include fees for other types of transactions or for
providing various services to cardholders. As shown in table 1, issuers
assess fees for such services as providing cash advances or for making a
payment by telephone. According to our analysis, not all of these fees
were disclosed in the materials that issuers generally provide to
prospective or existing cardholders. Instead, card issuers told us that
they notified their customers of these fees by other means, such as
telephone conversations.

Table 1: Various Fees for Services and Transactions, Charged in 2005 on
Popular Large-Issuer Cards

                                        

       Fee type           Assessed for:       Number of     Average or range  
                                              cards that       of amounts     
                                             assessed fee  generally assessed 
                                               in 2005        (if charged)    
Cash advance      Obtaining cash or cash  26 of 27      3% of cash advance 
                     equivalent item using                 amount or $5       
                     credit card or                        minimum            
                     convenience checks                    
Balance transfer  Transferring all or     15 of 27      3% of transfer     
                     part of a balance from                amount or $5 to    
                     another creditor                      $10 minimum        
Foreign           Making purchases in a   19 of 27      3% of transaction  
transaction       foreign country or                    amount (in U.S.    
                     currency                              dollars)           
Returned          Using a convenience     20 of 27      $31                
convenience check check that the issuer                 
                     declines to honor                     
Stop payment      Requesting to stop      20 of 27      $26                
                     payment on a                          
                     convenience check                     
                     written against the                   
                     account                               
Telephone payment Arranging a single      N/Aa          $5-$15             
                     payment through a                     
                     customer service agent                
Duplicate copy of Obtaining a copy of a   N/Aa          $2-$13 per item    
account records   billing statement or                  
                     other record                          
Rush delivery of  Requesting that a card  N/Aa          $10-$20            
credit card       be sent by overnight                  
                     delivery                              

Source: GAO.

Note: Cash equivalent transactions include the purchase of items such as
money orders, lottery tickets and casino chips. Convenience checks are
personalized blank checks that issuers provide cardholders that can be
written against the available credit limit of a credit card account.

aWe were unable to determine the number of cards that assessed telephone
payment, duplicate copy, or rush delivery fees in 2005 because these fees
are not required by regulation to be disclosed with either mailed
solicitation letters or initial disclosure statements. We obtained
information about the level of these fees from a survey of the six largest
U.S. issuers.

While issuers generally have been including more kinds of fees on credit
cards, one category has decreased: most cards offered by the largest
issuers do not require cardholders to pay an annual fee. An annual fee is
a fixed fee that issuers charge cardholders each year they continue to own
that card. Almost 75 percent of cards we reviewed charged no annual fee in
2005 (among those that did, the range was from $30 to $90). Also, an
industry group representative told us that approximately 2 percent of
cards featured annual fee requirements. Some types of cards we reviewed
were more likely to apply an annual fee than others. For example, cards
that offered airline tickets in exchange for points that accrue to a
cardholder for using the card were likely to apply an annual fee. However,
among the 28 popular cards that we reviewed, not all of the cards that
offered rewards charged annual fees.

Recently, some issuers have introduced cards without certain penalty fees.
For example, one of the top six issuers has introduced a card that does
not charge a late fee, over-limit fee, cash-advance fee, returned payment
fee, or an annual fee. Another top-six issuer's card does not charge the
cardholder a late fee as long as one purchase is made during the billing
cycle. However, the issuer of this card may impose higher interest rates,
including above 30 percent, if the cardholder pays late or otherwise
defaults on the terms of the card.

Issuers Have Introduced Various Practices that Can Significantly Affect
Cardholder Costs

Popular credit cards offered by the six largest issuers involve various
issuer practices that can significantly affect the costs of using a credit
card for a cardholder. These included practices such as raising a card's
interest rates in response to cardholder behaviors and how payments are
allocated across balances.

Interest Rate Changes

One of the practices that can significantly increase the costs of using
typical credit cards is penalty pricing. Under this practice, the interest
rate applied to the balances on a card automatically can be increased in
response to behavior of the cardholder that appears to indicate that the
cardholder presents greater risk of loss to the issuer. For example,
representatives for one large issuer told us they automatically increase a
cardholder's interest rate if a cardholder makes a late payment or exceeds
the credit limit. Card disclosure documents now typically include
information about default rates, which represent the maximum penalty rate
that issuers can assess in response to cardholders' violations of the
terms of the card. According to an industry specialist at the Federal
Reserve, issuers first began the practice of assessing default interest
rates as a penalty for term violations in the late 1990s. As of 2005, all
but one of the cards we reviewed included default rates. The default rates
were generally much higher than rates that otherwise applied to purchases,
cash advances, or balance transfers. For example, the average default rate
across the 28 cards was 27.3 percent in 2005-up from the average of 23.8
percent in 2003-with as many as 7 cards charging rates over 30 percent.
Like many of the other rates assessed on these cards in 2005, default
rates generally were variable rates. Increases in average default rates
between 2003 and 2005 resulted from increases both in the prime rate,
which rose about 2 percentage points during this time, and the average
fixed amount that issuers added. On average, the fixed amount that issuers
added to the index rate in setting default rate levels increased from
about 19 percent in 2003 to 22 percent in 2005.

Four of the six largest issuers typically included conditions in their
disclosure documents that could allow the cardholder's interest rate to be
reduced from a higher penalty rate. For example some issuers would lower a
cardholders' rate for not paying late and otherwise abiding by the terms
of the card for a period of 6 or 12 consecutive months after the default
rate was imposed. However, at least one issuer indicated that higher
penalty rates would be charged on existing balances even after six months
of good behavior. This issuer assessed lower nonpenalty rates only on new
purchases or other new balances, while continuing to assess higher penalty
rates on the balance that existed when the cardholder was initially
assessed a higher penalty rate. This practice may significantly increase
costs to cardholders even after they've met the terms of their card
agreement for at least six months.

The specific conditions under which the largest issuers could raise a
cardholder's rate to the default level on the popular cards that we
analyzed varied. The disclosures for 26 of the 27 cards that included
default rates in 2005 stated that default rates could be assessed if the
cardholders made late payments. However, some cards would apply such
default rates only after multiple violations of card terms. For example,
issuers of 9 of the cards automatically would increase a cardholder's
rates in response to two late payments. Additionally, for 18 of the 28
cards, default rates could apply for exceeding the credit limit on the
card, and 10 cards could also impose such rates for returned payments.
Disclosure documents for 26 of the 27 cards that included default rates
also indicated that in response to these violations of terms, the interest
rate applicable to purchases could be increased to the default rate. In
addition, such violations would also cause issuers to increase the rates
applicable to cash advances on 16 of the cards, as well as increase rates
applicable to balance transfers on 24 of the cards.

According to a paper by a Federal Reserve Bank researcher, some issuers
began to increase cardholders' interest rates in the early 2000s for
actions they took with other creditors.28 According to this paper, these
issuers would increase rates when cardholders failed to make timely
payments to other creditors, such as other credit card issuers, utility
companies, and mortgage lenders. Becoming generally known as "universal
default," consumer groups criticized these practices. In 2004, OCC issued
guidance to the banks that it oversees, which include many of the largest
card
issuers, which addressed such practices.29 While OCC noted that the
repricing might be an appropriate way for banks to manage their credit
risk, they also noted that such practices could heighten a bank's
compliance and reputation risks. As a result, OCC urged national banks to
fully and prominently disclose in promotional materials the circumstances
under which a cardholder's interest rates, fees, or other terms could be
changed and whether the bank reserved the right to change these
unilaterally. Around the time of this guidance, issuers generally ceased
automatically repricing cardholders to default interest rates for risky
behavior exhibited with other creditors. Of the 28 popular large issuer
cards that we reviewed, three cards in 2005 included terms that would
allow the issuer to automatically raise a cardholder's rate to the default
rate if they made a late payment to another creditor.

Although the six largest U.S. issuers appear to have generally ceased
making automatic increases to a default rate for behavior with other
creditors, some continue to employ practices that allow them to seek to
raise a cardholder's interest rates in response to behaviors with other
creditors. During our review, representatives of four of these issuers
told us that they may seek to impose higher rates on a cardholder in
response to behaviors related to other creditors but that such increases
would be done as a change-in-terms, which can require prior notification,
rather than automatically.30 Regulation Z requires that the affected
cardholders be notified in writing of any such proposed changes in rate
terms at least 15 days before such change becomes effective.31 In
addition, under the laws of the states in which four of the six largest
issuers are chartered, cardholders would have to be given the right to opt
out of the change.32 However, issuer representatives told us that few
cardholders exercise this right. The ability of cardholders to opt out of
such increases also has been questioned. For example, one legal essay
noted that some cardholders may not be able to reject the changed terms of
their cards if the result would be a requirement to pay off the balance
immediately.33 In addition, an association for community banks that
provided comments to the Federal Reserve as part of the ongoing review of
card disclosures noted that 15 days does not provide consumers sufficient
time to make other credit arrangements if the new terms were undesirable.

Payment Allocation Method

The way that issuers allocate payments across balances also can increase
the costs of using the popular cards we reviewed. In this new credit
environment where different balances on a single account may be assessed
different interest rates, issuers have developed practices for allocating
the payments cardholders make to pay down their balance. For 23 of the 28
popular larger-issuer cards that we reviewed, cardholder payments would be
allocated first to the balance that is assessed the lowest rate of
interest.34 As a result, the low interest balance would have to be fully
paid before any of the cardholder's payment would pay down balances
assessed higher rates of interest. This practice can prolong the length of
time that issuers collect finance charges on the balances assessed higher
rates of interest.

Balance Computation Method

Additionally, some of the cards we reviewed use a balance computation
method that can increase cardholder costs. On some cards, issuers have
used a double-cycle billing method, which eliminates the interest-free
period of a consumer who moves from nonrevolving to revolving status,
according to Federal Reserve staff. In other words, in cases where a
cardholder, with no previous balance, fails to pay the entire balance of
new purchases by the payment due date, issuers compute interest on the
original balance that previously had been subject to an interest-free
period. This method is illustrated in figure 6.

Figure 6: How the Double-Cycle Billing Method Works

Note: We calculated finance charges assuming a 13.2 percent APR, 30-day
billing cycle, and that the cardholder's payment is credited on the first
day of cycle 2. We based our calculations on an average daily balance
method and daily compounding of finance charges.

In our review of 28 popular cards from the six largest issuers, we found
that two of the six issuers used the double-cycle billing method on one or
more popular cards between 2003 and 2005. The other four issuers indicated
they would only go back one cycle to impose finance charges.

New Practices Appear to Affect a Minority of Cardholders

Representatives of issuers, consumer groups, and others we interviewed
generally disagreed over whether the evolution of credit card pricing and
other practices has been beneficial to consumers. However, data provided
by the six largest issuers show that many of their active accounts did not
pay finance charges and that a minority of their cardholders were affected
by penalty charges in 2005.

Issuers Say Practices Benefit More Cardholders, but Critics Say Some
Practices Harm Consumers

The movement towards risk-based pricing for cards has allowed issuers to
offer better terms to some cardholders and more credit cards to others.
Spurred by increased competition, many issuers have adopted risk-based
pricing structures in which they assess different rates on cards depending
on the credit quality of the borrower. Under this pricing structure,
issuers have offered cards with lower rates to more creditworthy
borrowers, but also have offered credit to consumers who previously would
not have been considered sufficiently creditworthy. For example, about 70
percent of families held a credit card in 1989, but almost 75 percent held
a card by 2004, according to the Federal Reserve Board's Survey of
Consumer Finances. Cards for these less creditworthy consumers have
featured higher rates to reflect the higher repayment risk that such
consumers represented. For example, the initial purchase rates on the 28
popular cards offered by the six largest issuers ranged from about 8
percent to 19 percent in 2005.

According to card issuers, credit cards offer many more benefits to users
than they did in the past. For example, according to the six largest
issuers, credit cards are an increasingly convenient and secure form of
payment. These issuers told us credit cards are accepted at more than 23
million merchants worldwide, can be used to make purchases or obtain cash,
and are the predominant form of payment for purchases made on the
Internet. They also told us that rewards, such as cash-back and airline
travel, as well as other benefits, such as rental car insurance or lost
luggage protection, also have become standard. Issuers additionally noted
that credit cards are reducing the need for cash. Finally, they noted that
cardholders typically are not responsible for loss, theft, fraud, or
misuse of their credit cards by unauthorized users, and issuers often
assist cardholders that are victims of identity theft.

In contrast, according to some consumer groups and others, the newer
pricing structures have resulted in many negative outcomes for some
consumers. Some consumer advocates noted adverse consequences of offering
credit, especially at higher interest rates, to less creditworthy
consumers. For example, lower-income or young consumers, who do not have
the financial means to carry credit card debt, could worsen their
financial condition.35 In addition, consumer groups and academics said
that various penalty fees could increase significantly the costs of using
cards for some consumers. Some also argued that card issuers were overly
aggressive in their assessment of penalty fees. For instance, a
representative of a consumer group noted that issuers do not reject
cardholders' purchases during the sale authorization, even if the
transaction would put the cardholder over the card's credit limit, and yet
will likely later assess that cardholder an over-limit fee and also may
penalize them with a higher interest rate. Furthermore, staff for one
banking regulator told us that they have received complaints from
consumers who were assessed over-limit fees that resulted from the balance
on their accounts going over their credit limit because their card issuer
assessed them a late fee. At the same time, credit card issuers have
incentives not to be overly aggressive with their assessment of penalty
charges. For example, Federal Reserve representatives told us that major
card issuers with long-term franchise value are concerned that their banks
not be perceived as engaging in predatory lending because this could pose
a serious risk to their brand reputation. As a result, they explained that
issuers may be wary of charging fees that could be considered excessive or
imposing interest rates that might be viewed as potentially abusive. In
contrast, these officials noted that some issuers, such as those that
focus on lending to consumers with lower credit quality, may be less
concerned about their firm's reputation and, therefore, more likely to
charge higher fees.

Controversy also surrounds whether higher fees and other charges were
commensurate with the risks that issuers faced. Consumer groups and others
questioned whether the penalty interest rates and fees were justifiable.
For example, one consumer group questioned whether submitting a credit
card payment one day late made a cardholder so risky that it justified
doubling or tripling the interest rate assessed on that account. Also, as
the result of concerns over the level of penalty fees being assessed by
banks in the United Kingdom, a regulator there has recently announced that
penalty fees greater than 12 pounds (about $23) may be challenged as
unfair unless they can be justified by exceptional factors.36
Representatives of several of the issuers with whom we spoke told us that
the levels of the penalty fees they assess generally were set by
considering various factors. For example, they noted that higher fees help
to offset the increased risk of loss posed by cardholders who pay late or
engage in other negative behaviors. Additionally, they noted a 2006 study,
which compared the assessment of penalty fees that credit card banks
charged to bankruptcy rates in the states in which their cards were
marketed, and found that late fee assessments were correlated with
bankruptcy rates.37 Some also noted that increased fee levels reflected
increased operating costs; for example, not receiving payments when due
can cause the issuer to incur increased costs, such as those incurred by
having to call cardholders to request payment. Representatives for four of
the largest issuers also told us that their fee levels were influenced by
what others in the marketplace were charging.

Concerns also have been expressed about whether consumers adequately
consider the potential effect of penalty interest rates and fees when they
use their cards. For example, one academic researcher, who has written
several papers about the credit card industry, told us that many consumers
do not consider the effect of the costs that can accrue to them after they
begin using a credit card. According to this researcher, many consumers
focus primarily on the amount of the interest rate for purchases when
deciding to obtain a new credit card and give less consideration to the
level of penalty charges and rates that could apply if they were to miss a
payment or violate some other term of their card agreement. An analyst
that studies the credit card industry for large investors said that
consumers can obtain low introductory rates but can lose them very easily
before the introductory period expires.

Most Active Accounts Are Assessed Lower Rates Than in the Past

As noted previously, the average credit card interest rate assessed for
purchases has declined from almost 20 percent, that prevailed until the
late 1980s, to around 12 percent, as of 2005. In addition, the six largest
issuers-whose accounts represent 61 percent of all U.S. accounts-reported
to us that the majority of their cardholders in 2005 had cards with
interest rates lower than the rate that generally applied to all
cardholders prior to about 1990. According to these issuers, about 80
percent of active accounts were assessed interest rates below 20 percent
as of December 31, 2005, with
more than 40 percent having rates below 15 percent.38 However, the
proportion of active accounts assessed rates below 15 percent declined
since 2003, when 71 percent received such rates. According to issuer
representatives, a greater number of active accounts were assessed higher
interest rates in 2004 and 2005 primarily because of changes in the prime
rate to which many cards' variable rates are indexed. Nevertheless,
cardholders today have much greater access to cards with lower interest
rates than existed when all cards charged a single fixed rate.

A large number of cardholders appear to avoid paying any significant
interest charges. Many cardholders do not revolve a balance from month to
month, but instead pay off the balance owed in full at the end of each
month. Such cardholders are often referred to as convenience users.
According to one estimate, about 42 percent of cardholders are convenience
users.39 As a result, many of these cardholders availed themselves of the
benefits of their cards without incurring any direct expenses. Similarly,
the six largest issuers reported to us that almost half, or 48 percent, of
their active accounts did not pay a finance charge in at least 10 months
in 2005, similar to the 47 percent that did so in 2003 and 2004.

Minority of Cardholders Appear to Be Affected by Penalty Charges Assessed
by the Largest U.S. Issuers

Penalty interest rates and fees appear to affect a minority of the largest
six issuers' cardholders.40 No comprehensive sources existed to show the
extent to which U.S. cardholders were paying penalty interest rates, but,
according to data provided by the six largest issuers, a small proportion
of their active accounts were being assessed interest rates above 25
percent-which we determined were likely to represent penalty rates.
However, this proportion had more than doubled over a two-year period by
having increased from 5 percent at the end of 2003 to 10 percent in 2004
and 11 percent in 2005.

Although still representing a minority of cardholders, cardholders paying
at least one type of penalty fee were a significant proportion of all
cardholders. According to the six largest issuers, 35 percent of their
active accounts had been assessed at least one late fee in 2005. These
issuers reported that their late fee assessments averaged $30.92 per
active account. Additionally, these issuers reported that they assessed
over-limit fees on 13 percent of active accounts in 2005, with an average
over-limit fee of $9.49 per active account.

Weaknesses in Credit Card Disclosures Appear to Hinder Cardholder
Understanding of Fees and Other Practices That Can Affect Their Costs

The disclosures that issuers representing the majority of credit card
accounts use to provide information about the costs and terms of using
credit cards had serious weaknesses that likely reduce their usefulness to
consumers. These disclosures are the primary means under federal law for
protecting consumers against inaccurate and unfair credit card practices.
The disclosures we analyzed had weaknesses, such as presenting information
written at a level too difficult for the average consumer to understand,
and design features, such as text placement and font sizes, that did not
conform to guidance for creating easily readable documents. When
attempting to use these disclosures, cardholders were often unable to
identify key rates or terms and often failed to understand the information
in these documents. Several factors help explain these weaknesses,
including outdated regulations and guidance. With the intention of
improving the information that consumers receive, the Federal Reserve has
initiated a comprehensive review of the regulations that govern credit
card disclosures. Various suggestions have been made to improve
disclosures, including testing them with consumers. While Federal Reserve
staff have begun to involve consumers in their efforts, they are still
attempting to determine the best form and content of any revised
disclosures. Without clear, understandable information, consumers risk
making poor choices about using credit cards, which could unnecessarily
result in higher costs to use them.

Mandatory Disclosure of Credit Card Terms and Conditions Is the Primary
Means Regulators Use for Ensuring Competitive Credit Card Pricing

Having adequately informed consumers that spur competition among issuers
is the primary way that credit card pricing is regulated in the United
States. Under federal law, a national bank may charge interest on any loan
at a rate permitted by the law of the state in which the bank is
located.41 In 1978, the U.S. Supreme Court ruled that a national bank is
"located" in the state in which it is chartered, and, therefore, the
amount of the interest rates charged by a national bank are subject only
to the laws of the state in which it is chartered, even if its lending
activities occur elsewhere.42 As a result, the largest credit card issuing
banks are chartered in states that either lacked interest rate caps or had
very high caps from which they would offer credit cards to customers in
other states. This ability to "export" their chartered states' interest
rates effectively removed any caps applicable to interest rates on the
cards from these banks. In 1996, the U.S. Supreme Court determined that
fees charged on credit extended by national banks are a form of interest,
allowing issuers to also export the level of fees allowable in their state
of charter to their customers nationwide, which effectively removed any
caps on the level of fees that these banks could charge.43

In the absence of federal regulatory limitations on the rates and fees
that card issuers can assess, the primary means that U.S. banking
regulators have for influencing the level of such charges is by
facilitating competition among issuers, which, in turn, is highly
dependent on informed consumers. The Truth in Lending Act of 1968 (TILA)
mandates certain disclosures aimed at informing consumers about the cost
of credit. In approving TILA, Congress intended that the required
disclosures would foster price competition among card issuers by enabling
consumers to discern differences among cards while shopping for credit.
TILA also states that its purpose is to assure that the consumer will be
able to compare more readily the various credit terms available to him or
her and avoid the uninformed use of credit. As authorized under TILA, the
Federal Reserve has promulgated Regulation Z to carry out the purposes of
TILA. The Federal Reserve, along with the other federal banking agencies,
enforces compliance with Regulation Z with respect to the depository
institutions under their respective supervision.

In general, TILA and the accompanying provisions of Regulation Z require
credit card issuers to inform potential and existing customers about
specific pricing terms at specific times. For example, card issuers are
required to make various disclosures when soliciting potential customers,
as well as on the actual applications for credit. On or with card
applications and solicitations, issuers generally are required to present
pricing terms, including the interest rates and various fees that apply to
a card, as well as information about how finance charges are calculated,
among other things. Issuers also are required to provide cardholders with
specified disclosures prior to the cardholder's first transaction,
periodically in billing statements, upon changes to terms and conditions
pertaining to the account, and upon account renewal. For example, in
periodic statements, which issuers typically provide monthly to active
cardholders, issuers are required to provide detailed information about
the transactions on the account during the billing cycle, including
purchases and payments, and are to disclose the amount of finance charges
that accrued on the cardholder's outstanding balance and detail the type
and amount of fees assessed on the account, among other things.

In addition to the required timing and content of disclosures, issuers
also must adhere to various formatting requirements. For example, since
1989, certain pricing terms must be disclosed in direct mail, telephone,
and other applications and solicitations and presented in a tabular format
on mailed applications or solicitations.44 This table, generally referred
to as the Schumer box, must contain information about the interest rates
and fees that could be assessed to the cardholder, as well as information
about how finance charges are calculated, among other things.45 According
to a Federal Reserve representative, the Schumer box is designed to be
easy for consumers to read and use for comparing credit cards. According
to a consumer group representative, an effective regulatory disclosure is
one that stimulates competition among issuers; the introduction of the
Schumer box in the late 1980s preceded the increased price competition in
the credit card market in the early 1990s and the movement away from
uniform credit card products.

Not all fees that are charged by card issuers must be disclosed in the
Schumer box. Regulation Z does not require that issuers disclose fees
unrelated to the opening of an account. For example, according to the
Official Staff Interpretations of Regulation Z (staff interpretations),
nonperiodic fees, such as fees charged for reproducing billing statements
or reissuing a lost or stolen card, are not required to be disclosed.
Staff interpretations, which are compiled and published in a supplement to
Regulation Z, are a means of guiding issuers on the requirements of
Regulation Z.46 Staff interpretations also explain that various fees are
not required in initial disclosure statements, such as a fee to expedite
the delivery of a credit card or, under certain circumstances, a fee for
arranging a single payment by telephone. However, issuers we surveyed told
us they inform cardholders about these other fees at the time the
cardholders request the service, rather than in a disclosure document.

Although Congress authorized solely the Federal Reserve to adopt
regulations to implement the purposes of TILA, other federal banking
regulators, under their authority to ensure the safety and soundness of
depository institutions, have undertaken initiatives to improve the credit
card disclosures made by the institutions under their supervision. For
example, the regulator of national banks, OCC, issued an advisory letter
in 2004 alerting banks of its concerns regarding certain credit card
marketing and account management practices that may expose a bank to
compliance and reputation risks. One such practice involved the marketing
of promotional interest rates and conditions under which issuers reprice
accounts to higher interest rates.47 In its advisory letter, OCC
recommended that issuers disclose any limits on the applicability of
promotional interest rates, such as the duration of the rates and the
circumstances that could shorten the promotional rate period or cause
rates to increase. Additionally, OCC advised issuers to disclose the
circumstances under which they could increase a consumer's interest rate
or fees, such as for failure to make timely payments to another creditor.

Credit Card Disclosures Typically Provided to Many Consumers Have Various
Weaknesses

The disclosures that credit card issuers typically provide to potential
and new cardholders had various weaknesses that reduced their usefulness
to consumers. These weaknesses affecting the disclosure materials included
the typical grade level required to comprehend them, their poor
organization and formatting of information, and their excessive detail and
length.

Disclosures Written at Too High a Level

The typical credit card disclosure documents contained content that was
written at a level above that likely to be understandable by many
consumers. To assess the readability of typical credit card disclosures,
we contracted with a private usability consultant to evaluate the two
primary disclosure documents for four popular, widely-held cards (one each
from four large credit card issuers). The two documents were (1) a direct
mail solicitation letter and application, which must include information
about the costs and fees associated with the card; and (2) the cardmember
agreement that contains the full range of terms and conditions applicable
to the card.48 Through visual inspection, we determined that this set of
disclosures appeared representative of the disclosures for the 28 cards we
reviewed from the six largest issuers that accounted for the majority of
cardholders in the United States. To determine the level of education
likely needed for someone to understand these disclosures, the usability
consultant used computer software programs that applied three widely used
readability formulas to the entire text of the disclosures. These formulas
determined the readability of written material based on quantitative
measures, such as average number of syllables in words or numbers of words
in sentences. For more information about the usability consultant's
analyses, see appendix I.

On the basis of the usability consultant's analysis, the disclosure
documents provided to many cardholders likely were written at a level too
high for the average individual to understand. The consultant found that
the disclosures on average were written at a reading level commensurate
with about a tenth- to twelfth-grade education. According to the
consultant's analysis, understanding the disclosures in the solicitation
letters would require an eleventh-grade level of reading comprehension,
while understanding the cardmember agreements would require about a
twelfth-grade education. A consumer advocacy group that tested the reading
level needed to understand credit card disclosures arrived at a similar
conclusion. In a comment letter to the Federal Reserve, this consumer
group noted it had measured a typical passage from a change-in-terms
notice on how issuers calculate finance charges using one of the
readability formulas and that this passage required a twelfth-grade
reading level.

These disclosure documents were written such that understanding them
required a higher reading level than that attained by many U.S.
cardholders. For example, a nationwide assessment of the reading level of
the U.S. population cited by the usability consultant indicated that
nearly half of the adult population in the United States reads at or below
the eighth-grade level.49 Similarly, to ensure that the information that
public companies are required to disclose to prospective investors is
adequately understandable, the Securities and Exchange Commission (SEC)
recommends that such disclosure materials be written at a sixth- to
eighth-grade level.50

In addition to the average reading level, certain portions of the typical
disclosure documents provided by the large issuers required even higher
reading levels to be understandable. For example, the information that
appeared in cardmember agreements about annual percentage rates, grace
periods, balance computation, and payment allocation methods required a
minimum of a fifteenth-grade education, which is the equivalent of 3 years
of college education. Similarly, text in the documents describing the
interest rates applicable to one issuer's card were written at a
twenty-seventh-grade level. However, not all text in the disclosures
required such high levels. For example, the consultant found that the
information about fees that generally appeared in solicitation letters
required only a seventh- and eighth-grade reading level to be
understandable. Solicitation letters likely required lower reading levels
to be understandable because they generally included more information in a
tabular format than cardmember agreements.

Poor Organization and Formatting

The disclosure documents the consultant evaluated did not use designs,
including effective organizational structures and formatting, that would
have made them more useful to consumers. To assess the adequacy of the
design of the typical large issuer credit card solicitation letters and
cardmember agreements, the consultant evaluated the extent to which these
disclosures adhered to generally accepted industry standards for effective
organizational structures and designs intended to make documents easy to
read. In the absence of best practices and guidelines specifically for
credit card disclosures, the consultant used knowledge of plain language,
publications design guidelines, and industry best practices and also
compared the credit card disclosure documents to the guidelines in the
Securities and Exchange Commission's plain English handbook. The usability
consultant used these standards to identify aspects of the design of the
typical card disclosure documents that could cause consumers using them to
encounter problems.

On the basis of this analysis, the usability consultant concluded that the
typical credit card disclosures lacked effective organization. For
example, the disclosure documents frequently placed pertinent information
toward the end of sentences. Figure 7 illustrates an example taken from
the cardmember agreement of one of the large issuers that shows that a
consumer would need to read through considerable amounts of text before
reaching the important information, in this case the amount of the annual
percentage rate (APR) for purchases. Best practices would dictate that
important information-the amount of the APR-be presented first, with the
less important information-the explanation of how the APR is
determined-placed last.

Figure 7: Example of Important Information Not Prominently Presented in
Typical Credit Card Disclosure Documents

In addition, the disclosure documents often failed to group relevant
information together. Although one of the disclosure formats mandated by
law-the Schumer box-has been praised as having simplified the presentation
of complex information, our consultant observed that the amount of
information that issuers typically presented in the box compromised the
benefits of using a tabular format. Specifically, the typical credit card
solicitation letter, which includes a Schumer box, may be causing
difficulties for consumers because related information generally is not
grouped appropriately, as shown in figure 8.

Figure 8: Example of How Related Information Was Not Being Grouped
Together in Typical Credit Card Disclosure Documents

As shown in figure 8, information about the APR that would apply to
purchases made with the card appeared in three different locations. The
first row includes the current prevailing rate of the purchase APR; text
that describes how the level of the purchase APR could vary according to
an underlying rate, such as the prime rate, is included in the third row;
and text describing how the issuer determines the level of this underlying
rate is included in the footnotes. According to the consultant, grouping
such related information together likely would help readers to more easily
understand the material.

In addition, of the four issuers whose materials were analyzed, three
provided a single document with all relevant information in a single
cardmember agreement, but one issuer provided the information in separate
documents. For example, this issuer disclosed specific information about
the actual amount of rates and fees in one document and presented
information about how such rates were determined in another document.
According to the readability consultant, disclosures in multiple documents
can be more difficult for the reader to use because they may require more
work to find information.

Formatting weaknesses also likely reduced the usefulness of typical credit
card disclosure documents. The specific formatting issues were as follows:

o Font sizes. According to the usability consultant's analysis, many of
the disclosure documents used font sizes that were difficult to read and
could hinder consumers' ability to find information. For example, the
consultant found extensive use of small and condensed typeface in
cardmember agreements and in footnotes in solicitation materials when best
practices would suggest using a larger, more legible font size. Figure 9
contains an illustration of how the disclosures used condensed text that
makes the font appear smaller than it actually is. Multiple consumers and
consumer groups who provided comments to the Federal Reserve noted that
credit card disclosures were written in a small print that reduces a
consumer's ability to read or understand the document. For example, a
consumer who provided comments to the Federal Reserve referred to the text
in card disclosures as "mice type." This example also illustrates how
notes to the text, which should be less important, were the same size and
thus given the same visual emphasis as the text inside the box. Consumers
attempting to read such disclosures may have difficulty determining which
information is more important.

Figure 9: Example of How Use of Small Font Sizes Reduces Readability in
Typical Credit Card Disclosure Documents

Note: Graphic shown is the actual size it appears in issuer disclosure
documents. Graphic is intentionally portioned off to focus attention to
headings.

o Ineffective font placements. According to the usability consultant, some
issuers' efforts to distinguish text using different font types sometimes
had the opposite effect. The consultant found that the disclosures from
all four issuers emphasized large amounts of text with all capital letters
and sometimes boldface. According to the consultant, formatting large
blocks of text in capitals makes it harder to read because the shapes of
the words disappear, forcing the reader to slow down and study each letter
(see figure 10). In a comment letter to the Federal Reserve, an industry
group recommended that boldfaced or capitalized text should be used
discriminately, because in its experience, excessive use of such font
types caused disclosures to lose all effectiveness. SEC's guidelines for
producing clear disclosures contain similar suggestions.

Figure 10: Example of How Use of Ineffective Font Types Reduces
Readability in Typical Credit Card Disclosure Documents

o Selecting text for emphasis. According to the usability consultant, most
of the disclosure documents unnecessarily emphasized specific terms.
Inappropriate emphasis of such material could distract readers from more
important messages. Figure 11 contains a passage from one cardmember
agreement that the readability consultant singled out for its emphasis of
the term "periodic finance charge," which is repeated six times in this
example. According to the consultant, the use of boldface and capitalized
text calls attention to the word, potentially requiring readers to work
harder to understand the entire passage's message.

Figure 11: Example of How Use of Inappropriate Emphasis Reduces
Readability in Typical Credit Card Disclosure Documents

o Use of headings. According to the usability consultant, disclosure
documents from three of the four issuers analyzed contained headings that
were difficult to distinguish from surrounding text. Headings, according
to the consultant, provide a visual hierarchy to help readers quickly
identify information in a lengthy document. Good headers are easy to
identify and use meaningful labels. Figure 12 illustrates two examples of
how the credit card disclosure documents failed to use headings
effectively.

Figure 12: Example of Ineffective and Effective Use of Headings in Typical
Credit Card Disclosure Documents

In the first example, the headings contained an unnecessary string of
numbers that the consultant found would make locating a specific topic in
the text more difficult. As a result, readers would need to actively
ignore the string of numbers until the middle of the line to find what
they wanted. The consultant noted that such numbers might be useful if
this document had a table of contents that referred to the numbers, but it
did not. In the second example, the consultant noted that a reader's
ability to locate information using the headings in this document was
hindered because the headings were not made more visually distinct, but
instead were aligned with other text and printed in the same type size as
the text that followed. As a result, these headings blended in with the
text. Furthermore, the consultant noted that because the term "Annual
Percentage Rates" was given the same visual treatment as the two headings
in the example, finding headings quickly was made even more difficult. In
contrast, figure 12 also shows an example that the consultant identified
in one of the disclosure documents that was an effective use of headings.

o Presentation techniques. According to the usability consultant, the
disclosure documents analyzed did not use presentation techniques, such as
tables, bulleted lists, and graphics, that could help to simplify the
presentation of complicated concepts, especially in the cardmember
agreements. Best practices for document design suggest using tables and
bulleted lists to simplify the presentation of complex information.
Instead, the usability consultant noted that all the cardmember agreements
reviewed almost exclusively employed undifferentiated blocks of text,
potentially hindering clear communication of complex information, such as
the multiple-step procedures issuers use for calculating a cardholder's
minimum required payment. Figure 13 below presents two samples of text
from different cardmember agreements describing how minimum payments are
calculated. According to the consultant, the sample that used a bulleted
list was easier to read than the one formatted as a paragraph. Also, an
issuer stated in a letter to the Federal Reserve that their consumers have
welcomed the issuer's use of bullets to format information, emphasizing
the concept that the visual layout of information either facilitates or
hinders consumer understanding.

Figure 13: Example of How Presentation Techniques Can Affect Readability
in Typical Credit Card Disclosure Documents

Excessive Complexity and Volume of Information

The content of typical credit card disclosure documents generally was
overly complex and presented in too much detail, such as by using
unfamiliar or complex terms to describe simple concepts. For example, the
usability consultant identified one cardmember agreement that used the
term "rolling consecutive twelve billing cycle period" instead of saying
"over the course of the next 12 billing statements" or "next 12 months"-if
that was appropriate. Further, a number of consumers, consumer advocacy
groups, and government and private entities that have provided comments to
the Federal Reserve agreed that typical credit card disclosures are
written in complex language that hinders consumers' understanding. For
example, a consumer wrote that disclosure documents were "loaded with
booby traps designed to trip consumers, and written in intentionally
impenetrable and confusing language." One of the consumer advocacy groups
stated the disclosures were "full of dense, impenetrable legal jargon that
even lawyers and seasoned consumer advocates have difficulty
understanding." In addition, the consultant noted that many of the
disclosures, including solicitation letters and cardmember agreements,
contained overly long and complex sentences that increase the effort a
reader must devote to understanding the text. Figure 14 contains two
examples of instances in which the disclosure documents used uncommon
words and phrases to express simple concepts.

Figure 14: Examples of How Removing Overly Complex Language Can Improve
Readability in Typical Credit Card Disclosure Documents

In addition, the disclosure documents regularly presented too much or
irrelevant detail. According to the usability consultant's analysis, the
credit card disclosures often contained superfluous information. For
example, figure 15 presents an example of text from one cardmember
agreement that described the actions the issuer would take if its normal
source for the rate information used to set its variable rates-The Wall
Street Journal-were to cease publication. Including such an arguably
unimportant detail lengthens and makes this disclosure more complex.
According to SEC best practices for creating clear disclosures, disclosure
documents are more effective when they adhere to the rule that less is
more. By omitting unnecessary details from disclosure documents, the
usability consultant indicated that consumers would be more likely to read
and understand the information they contain.

Figure 15: Example of Superfluous Detail in Typical Credit Card Disclosure
Documents

Consumer Confusion Indicated That Disclosures Were Not Communicating
Credit Card Cost Information Clearly

Many of the credit cardholders that were tested and interviewed as part of
our review exhibited confusion over various fees, practices, and other
terms that could affect the cost of using their credit cards. To
understand how well consumers could use typical credit card disclosure
documents to locate and understand information about card fees and other
practices, the usability consultant with whom we contracted used a sample
of cardholders to perform a usability assessment of the disclosure
documents from the four large issuers. As part of this assessment, the
consultant conducted one-on-one sessions with a total of 12 cardholders so
that each set of disclosures, which included a solicitation letter and a
cardmember agreement, was reviewed by 3 cardholders.51 Each of these
cardholders were asked to locate information about fee levels and rates,
the circumstances in which they would be imposed, and information about
changes in card terms. The consultant also tested the cardholders' ability
to explain various practices used by the issuer, such as the process for
determining the amount of the minimum monthly payment, by reading the
disclosure documents. Although the results of the usability testing cannot
be used to make generalizations about all cardholders, the consultant
selected cardholders based on the demographics of the U.S. adult
population, according to age, education level, and income, to ensure that
the cardholders tested were representative of the general population. In
addition, as part of this review, we conducted one-on-one interviews with
112 cardholders to learn about consumer behavior and knowledge about
various credit card terms and practices.52 Although we also selected these
cardholders to reflect the demographics of the U.S. adult population, with
respect to age, education level, and income, the results of these
interviews cannot be generalized to the population of all U.S.
cardholders.53

Based on the work with consumers, specific aspects of credit card terms
that apparently were not well understood included:

o Default interest rates. Although issuers can penalize cardholders for
violating the terms of the card, such as by making late payments or by
increasing the interest rates in effect on the cardholder's account to
rates as high as 30 percent or more, only about half of the cardholders
that the usability consultant tested were able to use the typical credit
card disclosure documents to successfully identify the default rate and
the circumstances that would trigger rate increases for these cards. In
addition, the usability consultant observed the cardholders could not
identify this information easily. Many also were unsure of their answers,
especially when rates were expressed as a "prime plus" number, indicating
the rate varied based on the prime rate. Locating information in the
typical cardmember agreement was especially difficult for cardholders, as
only 3 of 12 cardholders were able to use such documents to identify the
default interest rate applicable to the card. More importantly, only about
half of the cardholders tested using solicitation letters were able to
accurately determine what actions could potentially cause the default rate
to be imposed on these cards.

o Other penalty rate increases. Although card issuers generally reserve
the right to seek to raise a cardholder's rate in other situations, such
as when a cardholder makes a late payment to another issuer's credit card,
(even if the cardholder has not defaulted on the cardmember agreement),
about 71 percent of the 112 cardholders we interviewed were unsure or did
not believe that issuers could increase their rates in such a case. In
addition, about two-thirds of cardholders we interviewed were unaware or
did not believe that a drop in their credit score could cause an issuer to
seek to assess higher interest rates on their account.54

o Late payment fees. According to the usability assessment, many of the
cardholders had trouble using the disclosure documents to correctly
identify what would occur if a payment were to be received after the due
date printed in the billing statement. For example, nearly half of the
cardholders were unable to use the cardmember agreement to determine
whether a payment would be considered late based on the date the issuer
receives the payment or the date the payment was mailed or postmarked.
Additionally, the majority of the 112 cardholders we interviewed also
exhibited confusion over late fees: 52 percent indicated that they have
been surprised when their card company applied a fee or penalty to their
account.

o Using a credit card to obtain cash. Although the cardholders tested by
the consultant generally were able to use the disclosures to identify how
a transaction fee for a cash advance would be calculated, most were unable
to accurately use this information to determine the transaction fee for
withdrawing funds, usually because they neglected to consider the minimum
dollar amount, such as $5 or $10, that would be assessed.

o Grace periods. Almost all 12 cardholders in the usability assessment had
trouble using the solicitation letters to locate and define the grace
period, the period during which the a cardholder is not charged interest
on a balance. Instead, many cardholders incorrectly indicated that the
grace period was instead when their lower, promotional interest rates
would expire. Others incorrectly indicated that it was the amount of time
after the monthly bill's due date that a cardholder could submit a payment
without being charged a late fee.

o Balance computation method. Issuers use various methods to calculate
interest charges on outstanding balances, but only 1 of the 12 cardholders
the usability consultant tested correctly described average daily balance,
and none of the cardholders were able to describe two-cycle average daily
balance accurately. At least nine letters submitted to the Federal Reserve
in connection with its review of credit card disclosures noted that few
consumers understand balance computation methods as stated in disclosure
documents.

Perhaps as a result of weaknesses previously described, cardholders
generally avoid using the documents issuers provide with a new card to
improve their understanding of fees and practices. For example, many of
the cardholders interviewed as part of this report noted that the length,
format, and complexity of disclosures led them to generally disregard the
information contained in them. More than half (54 percent) of the 112
cardholders we interviewed indicated they read the disclosures provided
with a new card either not very closely or not at all. Instead, many
cardholders said they would call the issuer's customer service
representatives for information about their card's terms and conditions.
Cardholders also noted that the ability of issuers to change the terms and
conditions of a card at any time led them to generally disregard the
information contained in card disclosures. Regulation Z allows card
issuers to change the terms of credit cards provided that issuers notify
cardholders in writing within 15 days of the change. As a result, the
usability consultant observed some participants were dismissive of the
information in the disclosure documents because they were aware that
issuers could change anything.

Federal Reserve Effort to Revise Regulations Presents Opportunity to
Improve Disclosures

With liability concerns and outdated regulatory requirements seemingly
explaining the weaknesses in card disclosures, the Federal Reserve has
begun efforts to review its requirements for credit card disclosures.
Industry participants have advocated various ways in which the Federal
Reserve can act to improve these disclosures and otherwise assist
cardholders.

Regulations and Guidance May Contribute to Weaknesses in Current
Disclosures

Several factors may help explain why typical credit card disclosures
exhibit weaknesses that reduce their usefulness to cardholders. First,
issuers make decisions about the content and format of their disclosures
to limit potential legal liability. Issuer representatives told us that
the disclosures made in credit card solicitations and cardmember
agreements are written for legal purposes and in language that consumers
generally could not understand. For example, representatives for one large
issuer told us they cannot always state information in disclosures clearly
because the increased potential that simpler statements would be
misinterpreted would expose them to litigation. Similarly, a participant
of a symposium on credit card disclosures said that disclosures typically
became lengthier after the issuance of court rulings on consumer credit
issues. Issuers can attempt to reduce the risk of civil liability based on
their disclosures by closely following the formats that the Federal
Reserve has provided in its model forms and other guidance. According to
the regulations that govern card disclosures, issuers acting in good faith
compliance with any interpretation issued by a duly authorized official or
employee of the Federal Reserve are afforded protection from liability.55

Second, the regulations governing credit card disclosures have become
outdated. As noted earlier in this report, TILA and Regulation Z that
implements the act's provisions are intended to ensure that consumers have
adequate information about potential costs and other applicable terms and
conditions to make appropriate choices among competing credit cards. The
most recent comprehensive revisions to Regulation Z's open-end credit
rules occurred in 1989 to implement the provisions of the Fair Credit and
Charge Card Act. As we have found, the features and cost structures of
credit cards have changed considerably since then. An issuer
representative told us that current Schumer box requirements are not as
useful in presenting the more complicated structures of many current
cards. For example, they noted that it does not easily accommodate
information about the various cardholder actions that could trigger rate
increases, which they argued is now important information for consumers to
know when shopping for credit. As a result, some of the specific
requirements of Regulation Z that are intended to ensure that consumers
have accurate information instead may be diminishing the usefulness of
these disclosures.

Third, the guidance that the Federal Reserve provides issuers may not be
consistent with guidelines for producing clear, written documents. Based
on our analysis, many issuers appear to adhere to the formats and model
forms that the Federal Reserve staff included in the Official Staff
Interpretations of Regulation Z, which are prepared to help issuers comply
with the regulations. For example, the model forms present text about how
rates are determined in footnotes. However, as discussed previously, not
grouping related information undermines the usability of documents. The
Schumer box format requires a cardholder to look in several places, such
as in multiple rows in the table and in notes to the table, for
information about related aspects of the card. Similarly, the Federal
Reserve's model form for the Schumer box recommends that the information
about the transaction fee and interest rate for cash advances be disclosed
in different areas.

Finally, the way that issuers have implemented regulatory guidance may
have contributed to the weaknesses typical disclosure materials exhibited.
For example, in certain required disclosures, the terms "annual percentage
rate" and "finance charge," when used with a corresponding amount or
percentage rate, are required to be more conspicuous than any other
required disclosures.56 Staff guidance suggests that such terms may be
made more conspicuous by, for example, capitalizing these terms when other
disclosures are printed in lower case or by displaying these terms in
larger type relative to other disclosures, putting them in boldface print
or underlining them.57 Our usability consultant's analysis found that card
disclosure documents that followed this guidance were less effective
because they placed an inappropriate emphasis on terms. As shown
previously in figure 11, the use of bold and capital letters to emphasize
the term "finance charge" in the paragraph unnecessarily calls attention
to that term, potentially distracting readers from information that is
more important. The excerpt shown in figure 11 is from an initial
disclosure document which, according to Regulation Z, is subject to the
"more conspicuous" rule requiring emphasis of the terms "finance charge"
and "annual percentage rate."

Suggestions for Improving Disclosures Included Obtaining Input from
Consumers

With the intention of improving credit card disclosures, the Federal
Reserve has begun efforts to develop new regulations. According to its
2004 notice seeking public comments on Regulation Z, the Federal Reserve
hopes to address the length, complexity, and superfluous information of
disclosures and produce new disclosures that will be more useful in
helping consumers compare credit products.58 After the passage of the
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
(Bankruptcy Act) in October of that year, which included amendments to
TILA, the Federal Reserve sought additional comments from the public to
prepare to implement new disclosure requirements including disclosures
intended to advise consumers of the consequences of making only minimum
payments on credit cards.59 According to Federal Reserve staff, new credit
card disclosure regulations may not be in effect until sometime in 2007 or
2008 because of the time required to conduct consumer testing, modify the
existing regulations, and then seek comment on the revised regulation.

Industry participants and others have provided input to assist the Federal
Reserve in this effort. Based on the interviews we conducted, documents we
reviewed, and our analysis of the more than 280 comment letters submitted
to the Federal Reserve, issuers, consumer groups, and others provided
various suggestions to improve the content and format of credit card
disclosures, including:

o Reduce the amount of information disclosed. Some industry participants
said that some of the information currently presented in the Schumer box
could be removed because it is too complicated to disclose meaningfully or
otherwise lacks importance compared to other credit terms that are
arguably more important when choosing among cards. Such information
included the method for computing balances and the amount of the minimum
finance charge (the latter because it is typically so small, about 50
cents in 2005).

o Provide a shorter document that summarizes key information. Some
industry participants advocated that all key information that could
significantly affect a cardholder's costs be presented in a short document
that consumers could use to readily compare across cards, with all other
details included in a longer document. For example, although the Schumer
box includes several key pieces of information, it does not include other
information that could be as important for consumer decisions, such as
what actions could cause the issuer to raise the interest rate to the
default rate.

o Revise disclosure formats to improve readability. Various suggestions
were made to improve the readability of card disclosures, including making
more use of tables of contents, making labels and headings more prominent,
and presenting more information in tables instead of in text. Disclosure
documents also could use consistent wording that could allow for better
comparison of terms across cards.

Some issuers and others also told us that the new regulations should allow
for more flexibility in card disclosure formats. Regulations mandating
formats and font sizes were seen as precluding issuers from presenting
information in more effective ways. For example, one issuer already has
conducted market research and developed new formats for the Schumer box
that it says are more readable and contain new information important to
choosing cards in today's credit card environment, such as cardholder
actions that would trigger late fees or penalty interest rate increases.

In addition to suggestions about content, obtaining the input of
consumers, and possibly other professionals, was also seen as an important
way to make any new disclosures more useful. For example, participants in
a Federal Reserve Bank symposium on credit card disclosures recommended
that the Federal Reserve obtain the input of marketers, researchers, and
consumers as part of developing new disclosures. OCC staff suggested that
the Federal Reserve also employ qualitative research methods such as
in-depth interviews with consumers and others and that it conduct
usability testing.

Consumer testing can validate the effectiveness or measure the
comprehension of messages and information, and detect document design
problems. Many issuers are using some form of market research to test
their disclosure materials and have advocated improving disclosures by
seeking the input of marketers, researchers, and consumers.60 SEC also has
recently used consumer focus groups to test the format of new disclosures
related to mutual funds. According to an SEC staff member who participated
in this effort, their testing provided them with valuable information on
what consumers liked and disliked about some of the initial forms that the
regulator had drafted. In some cases, they learned that information that
SEC staff had considered necessary to include was not seen as important by
consumers. As a result, they revised the formats for these disclosures
substantially to make them simpler and may use graphics to present more
information rather than text.61 According to Federal Reserve staff, they
have begun to involve consumers in the development of new credit card
disclosures. According to Federal Reserve staff, they have already
conducted some consumer focus groups. In addition, they have contracted
with a design consultant and a market research firm to help them develop
some disclosure formats that they can then use in one-on-one testing with
consumers. However, the Federal Reserve staff told us they recognize the
challenge of designing disclosures that include all key information in a
clear manner, given the complexity of credit card products and the
different ways in which consumers use credit cards.

Although Credit Card Penalty Fees and Interest Could Increase
Indebtedness, the Extent to Which They Have Contributed to Bankruptcies
Was Unclear

The number of consumers filing for bankruptcy has risen more than six-fold
over the past 25 years, and various factors have been cited as possible
explanations. While some researchers have pointed to increases in total
debt or credit card debt in particular, others found that debt burdens and
other measures of financial distress had not increased and thus cite other
factors, such as a general decline in the stigma of going bankrupt or the
potentially increased costs of major life events such as health problems
or divorce. Some critics of the credit card industry have cited penalty
interest and fees as leading to increased financial distress; however, no
comprehensive data existed to determine the extent to which these charges
were contributing to consumer bankruptcies. Data provided by the six
largest card issuers indicated that unpaid interest and fees represented a
small portion of the amounts owed by cardholders that filed for
bankruptcy; however, these data alone were not sufficient to determine any
relationship between the charges and bankruptcies filed by cardholders.

Researchers Cited Various Factors as Explanations for Rise in Consumer
Bankruptcies

According to U.S. Department of Justice statistics, consumer bankruptcy
filings generally rose steadily from about 287,000 in 1980 to more than 2
million as of December 31, 2005, which represents about a 609 percent

increase over the last 25 years.62 Researchers have cited a number of
factors as possible explanations for the long-term trend.

Increase in Household Indebtedness

The total debt of American households is composed of mortgages on real
estate, which accounts for about 80 percent of the total, and consumer
credit debt, which includes revolving credit, such as balances owed on
credit cards, and nonrevolving credit, primarily consisting of auto loans.
According to Federal Reserve statistics, consumers' use of debt has
expanded over the last 25 years, increasing more than sevenfold from $1.4
trillion in 1980 to about $11.5 trillion in 2005. Some researchers pointed
to this rise in overall indebtedness as contributing to the rise in
bankruptcies. For example, a 2000 Congressional Budget Office summary of
bankruptcy research noted that various academic studies have argued that
consumer bankruptcies are either directly or indirectly caused by heavy
consumer indebtedness.

Rather than total debt, some researchers and others argue that the rise in
bankruptcies is related to the rise in credit card debt in particular.
According to the Federal Reserve's survey of consumer debt, the amount of
credit card debt reported as outstanding rose from about $237 billion to
more than $802 billion-a 238 percent increase between 1990 and 2005.63 One
academic researcher noted that the rise in bankruptcies and charge-offs by
banks in credit card accounts grew along with the increase in credit card
debt during the 1973 to 1996 period he examined.64 According to some
consumer groups, the growth of credit card debt is one of the primary
explanations of the increased prevalence of bankruptcies in the United
States. For example, one group noted in a 2005 testimony before Congress
that growth of credit card debt-particularly among lower and moderate
income households, consumers with poor credit scores, college students,
older Americans, and minorities-was contributing to the rise in
bankruptcies.65

However, other evidence indicates that increased indebtedness has not
severely affected the financial condition of U.S. households in general.
For example:

o Some researchers note that the ability of households to make payments on
debt appears to be keeping pace. For example, total household debt levels
as a percentage of income has remained relatively constant since the
1980s. According to the Federal Reserve, the aggregate debt burden
ratio-which covers monthly aggregate required payments of all households
on mortgage debt and both revolving and non-revolving consumer loans
relative to the aggregate monthly disposable income of all households-for
U.S. households has been above 13 percent in the last few years but
generally fluctuated between 11 percent and 14 percent from 1990 to 2005,
similar to the levels observed during the 1980s. According to one
researcher, although the debt burden ratio has risen since the 1980s, the
increase has been gradual and therefore cannot explain the six-fold
increase in consumer bankruptcy filings over the same period.

o Credit card debt remains a small portion of overall household debt, even
among households with the lowest income levels. According to the Federal
Reserve, credit card balances as a percentage of total household debt have
declined from 3.9 percent of total household debt in 1995 to just 3.0
percent as of 2004.

o The proportion of households that could be considered to be in financial
distress does not appear to be increasing significantly. According to the
Federal Reserve Board's Survey of Consumer Finances, the proportion of
households that could be considered to be in financial distress-those that
report debt-to-income ratios exceeding 40 percent and that have had at
least one delinquent payment within the last 60 days-was relatively stable
between 1995 and 2004. Further, the proportion of the lowest-income
households exhibiting greater levels of distress was lower in 2004 than it
was in the 1990s.

Other Explanations

With the effect of increased debt unclear, some researchers say that other
factors may better explain the surge in consumer bankruptcy filings over
the past 25 years. For example, the psychological stigma of declaring
bankruptcy may have lessened. One academic study examined a range of
variables that measured the credit risk (risk of default) of several
hundred thousand credit card accounts and found that because the
bankruptcy rate for the accounts was higher than the credit-risk variables
could explain, the higher rate must be the result of a reduced level of
stigma associated with filing.66 However, others have noted that reliably
measuring stigma is difficult. Some credit card issuers and other industry
associations also have argued that the pre-2005 bankruptcy code was too
debtor-friendly and created an incentive for consumers to borrow beyond
the ability to repay and file for bankruptcy.

In addition to the possibly reduced stigma, some academics, consumer
advocacy groups, and others noted that the normal life events that reduce
incomes or increase expenses for households may have a more serious effect
today. Events that can reduce household incomes include job losses, pay
cuts, or having a full-time position converted to part-time work. With
increasing health care costs, medical emergencies can affect household
expenses and debts more significantly than in the past, and, with more
families relying on two incomes, so can divorces. As a result, one
researcher explains that while these risks have always faced households,
their effect today may be more severe, which could explain higher
bankruptcy rates.67

Researchers who assert that life events are the primary explanation for
bankruptcy filings say that the role played by credit cards can vary. They
acknowledged that credit card debt can be a contributing factor to a
bankruptcy filing if a person's income is insufficient to meet all
financial obligations, including payments to credit card issuers. For
example, some individuals experiencing an adverse life event use credit
cards to provide additional funds to satisfy their financial obligations
temporarily but ultimately exhaust their ability to meet all obligations.
However, because the number of people that experience financially
troublesome life events likely exceeds the number of people who file for
bankruptcy, credit cards in other cases may serve as a critical temporary
source of funding they needed to avert a filing until that person's income
recovers or expenses diminish. (Appendix II provides additional detail
about the factors that may have affected the rise in consumer bankruptcy
filings and its relationship with credit card debt.)

The Extent to Which Credit Card Penalty Interest and Fees Contribute to
Consumer Bankruptcies Remains Controversial in the Absence of
Comprehensive Data

With very little information available on the financial condition of
individuals filing for bankruptcy, assessing the role played by credit
card debt, including penalty interest and fees, is difficult. According to
Department of Justice officials who oversee bankruptcy trustees in most
bankruptcy courts, the documents submitted as part of a bankruptcy filing
show the total debt owed to each card issuer but not how much of this
total consists of unpaid principal, interest, or fees. Similarly, these
Justice officials told us that the information that credit card issuers
submit when their customers reaffirm the debts owed to them-known as
proofs of claim-also indicate only the total amount owed. Likewise, the
amount of any penalty interest or fees owed as part of an outstanding
credit card balance is generally not required to be specified when a
credit card issuer seeks to obtain a court judgment that would require
payment from a customer as part of a collection case.

Opinions on the Link between Credit Card Practices and Bankruptcies Vary

Although little comprehensive data exist, some consumer groups and others
have argued that penalty interest and fees materially harm the financial
condition of some cardholders, including those that later file for
bankruptcy. Some researchers who study credit card issues argue that high
interest rates (applicable to standard purchases) for higher risk
cardholders, who are also frequently lower-income households, along with
penalty and default interest rates and fees, contribute to more consumer
bankruptcy filings. Another researcher who has studied issues relating to
credit cards and bankruptcy asserted that consumers focus too much on the
introductory purchase interest rates when shopping for credit cards and,
as a result, fail to pay close attention to penalty interest rates,
default clauses, and other fees that may significantly increase their
costs later. According to this researcher, it is doubtful that penalty
fees (such as late fees and over-limit fees) significantly affect
cardholders' debt levels, but accrued interest charges-particularly if a
cardholder is being assessed a high penalty interest rate-can
significantly worsen a cardholder's financial distress.

Some consumer advocacy groups and academics say that the credit card
industry practice of raising cardholder interest rates for default or
increased risky behavior likely has contributed to some consumer
bankruptcy filings. According to these groups, cardholders whose rates are
raised under such practices can find it more difficult to reduce their
credit card debt and experience more rapid declines in their overall
financial conditions as they struggle to make the higher payments that
such interest rates may entail. As noted earlier in this report, card
issuers have generally ceased practicing universal default, although
representatives for four of the six issuers told us that they might
increase their cardholder's rates if they saw indications that the
cardholder's risk has increased, such as how well they were making
payments to other creditors. In such cases, the card issuers said they
notify the cardholders in advance, by sending a change in terms notice,
and provide an option to cancel the account but keep the original terms
and conditions while paying off the balance.

Some organizations also have criticized the credit card industry for
targeting lower-income households that they believe may be more likely to
experience financial distress or file for bankruptcy. One of the
criticisms these organizations have made is that credit card companies
have been engaging in bottom-fishing by providing increasing amounts of
credit to riskier lower-income households that, as a result, may incur
greater levels of indebtedness than appropriate. For example, an official
from one consumer advocacy group testified in 2005 that card issuers
target lower-income and minority households and that this democratization
of credit has had serious negative consequences for these households,
placing them one financial emergency away from having to file for
bankruptcy.68 Some consumer advocacy group officials and academics noted
that card issuers market high-cost cards, with higher interest rates and
fees, to customers with poor credit histories-called subprime
customers-including some just coming out of bankruptcy. However, as noted
earlier, Federal Reserve survey data indicate that the proportion of
lower-income households-those with incomes below the fortieth
percentile-exhibiting financial distress has not increased since 1995. In
addition, in a June 2006 report that the Federal Reserve Board prepared
for Congress on the relationship between credit cards and bankruptcy, it
stated that credit card issuers do not solicit customers or extend credit
to them indiscriminately or without assessing their ability to repay debt
as issuers review all received applications for risk factors.69

In addition, representatives of credit card issuers argued that they do
not offer credit to those likely to become financially bankrupt because
they do not want to experience larger losses from higher-risk borrowers.
Because card accounts belonging to cardholders that filed for bankruptcy
account for a sizeable portion of issuers' charge-offs, card issuers do
not want to acquire new customers with high credit risk who may
subsequently file for bankruptcy. However, one academic researcher noted
that, if card issuers could increase their revenue and profits by offering
cards to more customers, including those with lower creditworthiness, they
could reasonably be expected to do so until the amount of expected losses
from bankruptcies becomes larger than the expected additional revenues
from the new customers.

In examining the relationship between the consumer credit industry and
bankruptcy, the Federal Reserve Board's 2006 report comes to many of the
same conclusions as the studies of other researchers we reviewed. The
Federal Reserve Board's report notes that despite large growth in the
proportion of households with credit cards and the rise in overall credit
card debt in recent decades, the debt-burden ratio and other potential
measures of financial distress have not significantly changed over this
period. The report also found that, while data on bankruptcy filings
indicate that most filers have accumulated consumer debt and the
proportion of filings and rise in revolving consumer debt have risen in
tandem, the decision to file for bankruptcy is complex and tends to be
driven by distress arising from life events such as job loss, divorce, or
uninsured illness.

Penalty Interest and Fees Can Affect Cardholders' Ability to Reduce
Outstanding Balances

While the effect of credit card penalty interest charges and fees on
consumer bankruptcies was unclear, such charges do reduce the ability of
cardholders to reduce their overall indebtedness. Generally, any penalty
charges that cardholders pay would consume funds that could have been used
to repay principal. Figure 16 below, compares two hypothetical cardholders
with identical initial outstanding balances of $2,000 that each make
monthly payments of $100. The figure shows how the total amounts of
principal are paid down by each of these two cardholders over the course
of 12 months, if penalty interest and fees apply. Specifically, cardholder
A (1) is assessed a late payment fee in three of those months and (2) has
his interest rate increased to a penalty rate of 29 percent after 6
months, while cardholder B does not experience any fees or penalty
interest charges. At the end of 12 months, the penalty and fees results in
cardholder A paying down $260 or 27 percent less of the total balance owed
than does cardholder B who makes on-time payments for the entire period.

Figure 16: Hypothetical Impact of Penalty Interest and Fee Charges on Two
Cardholders

In Some Court Cases, Cardholders Paid Significant Amounts of Penalty
Interest and Fees

In reviewing academic literature, hearings, and comment letters to the
Federal Reserve, we identified some court cases, including some involving
the top six issuers, that indicated that cardholders paid large amounts of
penalty interest and fees. For example:

o In a collections case in Ohio, the $1,963 balance on one cardholder's
credit card grew by 183 percent to $5,564 over 6 years, despite the
cardholder making few new purchases. According to the court's records,
although the cardholder made payments totaling $3,492 over this period,
the holder's balance grew as the result of fees and interest charges.
According to the court's determinations, between 1997 and 2003, the
cardholder was assessed a total of $9,056, including $1,518 in over-limit
fees, $1,160 in late fees, $369 in credit insurance, and $6,009 in
interest charges and other fees. Although the card issuer had sued to
collect, the judge rejected the issuer's collection demand, noting that
the cardholder was the victim of unreasonable, unconscionable practices.70

o In a June 2004 bankruptcy case filed in the U.S. Bankruptcy Court for
the Eastern District of Virginia, the debtor objected to the proofs of
claim filed by two companies that had been assigned the debt outstanding
on two of the debtor's credit cards. One of the assignees submitted
monthly statements for the credit card account it had assumed. The court
noted that over a two-year period (during which balance on the account
increased from $4,888 to $5,499), the debtor made only $236 in purchases
on the account, while making $3,058 in payments, all of which had gone to
pay finance charges, late charges, over-limit fees, bad check fees and
phone payment fees.71

o In a bankruptcy court case  filed in July 2003 in North Carolina, 18
debtors filed objections to the claims by one card issuer of the amounts
owed on their credit cards.72 In response to an inquiry by the judge, the
card issuer provided data for these accounts that showed that, in the
aggregate, 57 percent of the amounts owed by these 18 accounts at time of
their bankruptcy filings represented interest charges and fees. However,
the high percentage of interest and fees on these accounts may stem from
the size of these principal balances, as some were as low as $95 and none
was larger than $1,200.

Regulatory interagency guidance published in 2003 for all depository
institutions that issue credit cards may have reduced the potential for
cardholders who continue to make minimum payments to experience increasing
balances.73 In this guidance, regulators suggested that card issuers
require minimum repayment amounts so that cardholders' current balance
would be paid off-amortized-over a reasonable amount of time. In the past,
some issuers' minimum monthly payment formulas were such that a full
payment may have resulted in little or no principal being paid down,
particularly if the cardholder also was assessed any fees during a billing
cycle. In such cases, these cardholders' outstanding balances would
increase (or negatively amortize). In response to this guidance, some card
issuers we interviewed indicated that they have been changing their
minimum monthly payment formulas to ensure that credit card balances will
be paid off over a reasonable period by including at least some amount of
principal in each payment due.

Representatives of card issuers also told us that the regulatory guidance,
issued in 2003, addressing credit card workout programs-which allow a
distressed cardholder's account to be closed and repaid on a fixed
repayment schedule-and other forbearance practices, may help cardholders
experiencing financial distress avoid fees. In this guidance, the
regulators stated that (1) any workout program offered by an issuer should
be designed to have cardholders repay credit card debt within 60 months
and (2) to meet this time frame, interest rates and penalty fees may have
to be substantially reduced or eliminated so that principal can be repaid.
As a result, card issuers are expected to stop imposing penalty fees and
interest charges on delinquent card accounts or hardship card accounts
enrolled in repayment workout programs. According to this guidance,
issuers also can negotiate settlement agreements with cardholders by
forgiving a portion of the amount owed. In exchange, a cardholder can be
expected to pay the remaining balance either in a lump-sum payment or by
amortizing the balance over a several month period. Staff from OCC and an
association of credit counselors told us that, since the issuance of this
guidance, they have noticed that card issuers are increasingly both
reducing and waiving fees for cardholders who get into financial
difficulty. OCC officials also indicated that issuers prefer to facilitate
repayment of principal when borrowers adopt debt management plans and tend
to reduce or waive fees so the accounts can be amortized. On the other
hand, FDIC staff indicated that criteria for waiving fees and penalties
are not publicly disclosed to cardholders. These staff noted that most fee
waivers occurs after cardholders call and complain to the issuer and are
handled on a case-by-case basis.

Data for Some Bankrupt Cardholders Shows Little in Interest and Fees Owed,
but Comprehensive Data Were Not Available

Card issuers generally charge-off credit card loans that are no longer
collectible because they are in default for either missing a series of
payments or filing for bankruptcy. According to the data provided by the
six largest issuers, the number of accounts that these issuers
collectively had to charge off as a result of the cardholders filing for
bankruptcy ranged from about 1.3 million to 1.6 million annually between
2003 and 2005. Collectively, these represented about 1 percent of the six
issuers' active accounts during this period. Also, about 60 percent of the
accounts were 2 or more months delinquent at the time of the charge-off.
Most of the cardholders whose accounts were charged off as the result of a
bankruptcy owed small amounts of fees and interest charges at the time of
their bankruptcy filing. According to the data the six issuers provided,
the average account that they charged off in 2005 owed approximately
$6,200 at the time that bankruptcy was filed. Of this amount, the issuers
reported that on average 8 percent represented unpaid interest charges; 2
percent unpaid fees, including any unpaid penalty charges; and about 90
percent principal.

However, these data do not provide complete information about the extent
to which the financial condition of the cardholders may have been affected
by penalty interest and fee charges. First, the amounts that these issuers
reported to us as interest and fees due represent only the unpaid amounts
that were owed at the time of bankruptcy. According to representatives of
the issuers we contacted, each of their firms allocates the amount of any
payment received from their customers first to any outstanding interest
charges and fees, then allocates any remainder to the principal balance.
As a result, the amounts owed at the time of bankruptcy would not reflect
any previously paid fees or interest charges. According to representatives
of these issuers, data system and recordkeeping limitations prevented them
from providing us the amounts of penalty interest and fees assessed on
these accounts in the months prior to the bankruptcy filings.

Furthermore, the data do not include information on all of the issuers'
cardholders who went bankrupt, but only those whose accounts the issuers
charged off as the result of a bankruptcy filing. The issuers also charge
off the amounts owed by customers who are delinquent on their payments by
more than 180 days, and some of those cardholders may subsequently file
for bankruptcy. Such accounts may have accrued larger amounts of unpaid
penalty interest and fees than the accounts that were charged off for
bankruptcy after being delinquent for less than 180 days, because they
would have had more time to be assessed such charges. Representatives of
the six issuers told us that they do not maintain records on these
customers after they are charged off, and, in many cases, they sell the
accounts to collection firms.

Although Penalty Interest and Fees Likely Have Grown as a Share of Credit
Card Revenues, Large Card Issuers' Profitability Has Been Stable

Determining the extent to which penalty interest charges and fees
contribute to issuers' revenues and profits was difficult because issuers'
regulatory filings and other public sources do not include such detail.
According to bank regulators, industry analysts, and information reported
by the five largest issuers, we estimate that the majority of issuer
revenues-around 70 percent in recent years-came from interest charges, and
the portion attributable to penalty rates appears to be growing. Of the
remaining issuer revenues, penalty fees had increased and were estimated
to represent around 10 percent of total issuer revenues. The remainder of
issuer revenues came from fees that issuers receive for processing
merchants' card transactions and other types of consumer fees. The largest
credit card-issuing banks, which are generally the most profitable group
of lenders, have not greatly increased their profitability over the last
20 years.

Publicly Disclosed Data on Revenues and Profits from Penalty Interest and
Fees Are Limited

Determining the extent to which penalty interest and fee charges are
contributing to card issuer revenues and profits is difficult because
limited information is available from publicly disclosed financial
information. Credit card-issuing banks are subject to various regulations
that require them to publicly disclose information about their revenues
and expenses. As insured commercial banks, these institutions must file
reports of their financial condition, known as call reports, each quarter
with their respective federal regulatory agency. In call reports, the
banks provide comprehensive balance sheets and income statements
disclosing their earnings, including those from their credit card
operations. Although the call reports include separate lines for interest
income earned, this amount is not further segregated to show, for example,
income from the application of penalty interest rates. Similarly, banks
report their fee income on the call reports, but this amount includes
income from all types of fees, including those related to fiduciary
activities, and trading assets and liabilities and is not further
segregated to show how much a particular bank has earned from credit card
late fees, over-limit fees, or insufficient payment fees.

Another limitation of using call reports to assess the effect of penalty
charges on bank revenues is that these reports do not include detailed
information on credit card balances that a bank may have sold to other
investors through a securitization. As a way of raising additional funds
to lend to cardholders, many issuers combine the balances owed on large
groups of their accounts and sell these receivables as part of pools of
securitized assets to investors. In their call reports, the banks do not
report revenue received from cardholders whose balances have been sold
into credit card interest and fee income categories.74 The banks report
any gains or losses incurred from the sale of these pooled credit card
balances on their call reports as part of noninterest income. Credit card
issuing banks generally securitize more than 50 percent of their credit
card balances.

Although many card issuers, including most of the top 10 banks, are public
companies that must file various publicly available financial disclosures
on an ongoing basis with securities regulators, these filings also do not
disclose detailed information about penalty interest and fees. We reviewed
the public filings by the top five issuers and found that none of the
financial statements disaggregated interest income into standard interest
and penalty interest charges. In addition, we found that the five banks'
public financial statements also had not disaggregated their fee income
into penalty fees, service fees, and interchange fees. Instead, most of
these card issuers disaggregated their sources of revenue into two broad
categories-interest and noninterest income.

Majority of Card Issuer Revenues Came from Interest Charges

Although limited information is publicly disclosed, the majority of credit
card revenue appears to have come from interest charges. According to
regulators, information collected by firms that analyze the credit card
industry, and data reported to us by the five of the six largest issuers,
the proportion of net interest revenues to card issuers' total revenues is
as much as 71 percent. For example, five of the six largest issuers that
provided data to us reported that the proportion of their total U.S. card
operations income derived from interest charges ranged from 69 to 71
percent between 2003 and 2005.75

Figure 17: Example of a Typical Bank's Income Statement

We could not precisely determine the extent to which penalty interest
charges contribute to this revenue, although the amount of penalty
interest that issuers have been assessing has increased. In response to
our request, the six largest issuers reported the proportions of their
total cardholder accounts that were assessed various rates of interest for
2003 to 2005. On the basis of our analysis of the popular cards issued by
these largest issuers, all were charging, on average, default interest
rates of around 27 percent. According to the data these issuers provided,
the majority of cardholders paid interest rates below 20 percent, but the
proportion of their cardholders that paid interest rates at or above 25
percent-which likely represent default rates-has risen from 5 percent in
2003 to 11 percent in 2005. As shown in Figure 18, the proportion of
cardholders paying between 15 and 20 percent has also increased, but an
issuer representative told us that this likely was due to variable
interest rates on cards rising as a result of increases in U.S. market
interest rates over the last 3 years.

Figure 18: Proportion of Active Accounts of the Six Largest Card Issuers
with Various Interest Rates for Purchases, 2003 to 2005

Although we could not determine the amounts of penalty interest the card
issuers received, the increasing proportion of accounts assessed rates of
25 percent suggests a significant increase in interest revenues. For
example, a cardholder carrying a stable balance of $1,000 and paying 10
percent interest would pay approximately $100 annually, while a cardholder
carrying the same stable balance but paying 25 percent would pay $250 to
the card issuer annually. Although we did not obtain any information on
the size of balances owed by the cardholders of the largest issuers, the
proportion of the revenues these issuers received from cardholders paying
penalty interest rates may also be greater than 11 percent because such
cardholders may have balances larger than the $2,500 average for 2005 that
the issuers reported to us.

Fees Represented the Remainder of Issuer Revenues

The remaining card issuer revenues largely come from noninterest sources,
including merchant and consumer fees. Among these are penalty fees and
other consumer fees, as well as fees that issuers receive as part of
processing card transactions for merchants.

Penalty Fees Had Increased

Although no comprehensive data exist publicly, various sources we
identified indicated that penalty fees represent around 10 percent of
issuers' total revenues and had generally increased. We identified various
sources that gave estimates of penalty fee income as a percentage of card
issuers' total revenues that ranged from 9 to 13 percent:

o Analysis of the data the top six issuers provided to us indicated that
each of these issuers assessed an average of about $1.2 billion in penalty
fees for cardholders that made late payments or exceeded their credit
limit in 2005. In total, these six issuers reported assessing $7.4 billion
for these two penalty fees that year, about 12 percent of the $60.3
billion in total interest and consumer fees (penalty fees and fees for
other cardholder services).76

o According to a private firm that assists credit card banks with buying
and selling portfolios of credit card balance receivables, penalty fees
likely represented about 13 percent of total card issuer revenues.
According to an official with this firm, it calculated this estimate by
using information from 15 of the top 20 issuers, as well as many smaller
banks, that together represent up to 80 percent of the total credit card
industry.77

o An estimate from an industry research firm that publishes data on credit
card issuer activities indicated that penalty fees represented about 9
percent of issuer total revenues.

Issuers Also Collect Revenues from Processing Merchant Card Transactions

When a consumer makes a purchase with a credit card, the merchant selling
the goods does not receive the full purchase price. When the cardholder
presents the credit card to make a purchase, the merchant transmits the
cardholder's account number and the amount of the transaction to the
merchant's bank.78 The merchant's bank forwards this information to the
card association, such as Visa or Mastercard, requesting authorization for
the transaction. The card association forwards the authorization request
to the bank that issued the card to the cardholder. The issuing bank then
responds with its authorization or denial to the merchant's bank and then
to the merchant. After the transaction is approved, the issuing bank will
send the purchase amount, less an interchange fee, to the merchant's bank.
The interchange fee is established by the card association. Before
crediting the merchant's account, the merchant's bank will subtract a
servicing fee. These transaction fees-called interchange fees-are commonly
about 2 percent of the total purchase price. As shown in figure 19, the
issuing banks generally earn about $2.00 for every $100 purchased as
interchange fee revenue. In addition, the card association receives a
transaction processing fee. The card associations, such as Visa or
Mastercard, assess the amount of these fees and also conduct other
important activities, including imposing rules for issuing cards,
authorizing, clearing and settling transactions, advertising and promoting
the network brand, and allocating revenues among the merchants, merchant's
bank, and card issuer.

Figure 19: Example of a Typical Credit Card Purchase Transaction Showing
How Interchange Fees Paid by Merchants Are Allocated

In addition to penalty fees and interchange fees, the remaining
noninterest revenues for card issuers include other consumer fees or other
fees. Card issuers collect annual fees, cash advance fees, balance
transfer fees, and other fees from their cardholders. In addition, card
issuers collect other revenues, such as from credit insurance. According
to estimates by industry analyst firms, such revenues likely represented
about 8 to 9 percent of total issuer revenues.

Large Credit Card Issuer Profitability Has Been Stable

The profits of credit card-issuing banks, which are generally the most
profitable group of lenders, have been stable over the last 7 years. A
commonly used indicator of profitability is the return on assets ratio
(ROA). This ratio, which is calculated by dividing a company's income by
its total assets, shows how effectively a business uses its assets to
generate profits. In annual reports to Congress, the Federal Reserve
provides data on the profitability of larger credit card issuers-which
included 17 banks in 2004.79 Figure 20 shows the average ROA using pretax
income for these large credit card issuers compared with pretax ROA of all
commercial banks during the period 1986 to 2004. In general, the large
credit card issuers earned an average return of 3.12 percent over this
period, which was more than twice as much as the 1.49 percent average
returns earned by all commercial banks.

Figure 20: Average Pretax Return on Assets for Large Credit Card Banks and
All Commercial Banks, 1986 to 2004

As shown in the figure above, the ROA for larger credit card banks,
although fluctuating more widely during the 1990s, has generally been
stable since 1999, with returns in the 3.0 to 3.5 percent range. The
return on assets for the large card issuers peaked in 1993 at 4.1 percent
and has declined to 3.55 percent in 2004. In contrast, the profitability
of all commercial banks has been generally increasing over this period,
rising more than 140 percent between 1986 and 2004. Similar to the data
for all larger credit card issuers, data that five of the six largest
issuers provided to us indicated that their profitability also has been
stable in the 3 years between 2003 and 2005. These five issuers reported
that the return on their pretax earnings over their credit card balances
over this 3-year period ranged from about 3.6 percent to 4.1 percent.

Because of the high interest rates that issuers charge and variable rate
pricing, credit card lending generally is the most profitable type of
consumer lending, despite the higher rate of loan losses that issuers
incur on cards. Rates charged on credit cards generally are the highest of
any consumer lending category because they are extensions of credit that
are not secured by any collateral from the borrower. In contrast, other
common types of consumer lending, such as automobile loans or home
mortgages, involve the extension of a fixed amount of credit under fixed
terms of repayment that are secured by the underlying asset-the car or the
house-which the lender can repossess in the event of nonpayment by the
borrower. Collateral and fixed repayment terms reduce the risk of loss to
the lender, enabling them to charge lower interest rates on such loans. In
contrast, credit card loans, which are unsecured, available to large and
heterogeneous populations, and repayable on flexible terms at the
cardholders' convenience, present greater risks and have commensurately
higher interest rates. For example, according to Federal Reserve
statistics, the interest rate charged on cards by lenders generally has
averaged above 16 percent since 1980, while the average rate charged on
car loans since then has averaged around 10 percent. Borrowers may be more
likely to cease making payments on their credit cards if they become
financially distressed than they would on other loans that are secured by
an asset they could lose. For example, the percentage of credit card loans
that banks have had to charge off averaged above 4 percent between 2003
and 2005; in contrast, charge-offs for other types of consumer loans
average about 2 percent, with charge-offs for mortgage loans averaging
less than 1 percent, during those 3 years. (App. III provides additional
detail about the factors that affect the profitability of credit card
issuers.)

Conclusions

Credit cards provide various benefits to their cardholders, including
serving as a convenient way to pay for goods and services and providing
additional funds at rates of interest generally lower than those consumers
would have paid to borrow on cards in the past. However, the penalties for
late payments or other behaviors involving card use have risen
significantly in recent years. Card issuers note that their use of
risk-based pricing structures with multiple interest rates and fees has
allowed them to offer credit cards to cardholders at costs that are
commensurate with the risks presented by different types of customers,
including those who previously might not have been able to obtain credit
cards. On the whole, a large number of cardholders experience greater
benefits-either by using their cards for transactions without incurring
any direct expense or by enjoying generally lower costs for borrowing than
prevailed in the past-from using credit cards than was previously
possible, but the habits or financial circumstances of other cardholders
also could result in these consumers facing greater costs than they did in
the past.

The expansion and increased complexity of card rates, fees, and issuer
practices has heightened the need for consumers to receive clear
disclosures that allow them to more easily understand the costs of using
cards. In the absence of any regulatory or legal limits on the interest or
fees that cards can impose, providing consumers with adequate information
on credit card costs and practices is critical to ensuring that vigorous
competition among card issuers produces a market that provides the best
possible rates and terms for U.S. consumers. Our work indicates that the
disclosure materials that the largest card issuers typically provided
under the existing regulations governing credit cards had many serious
weaknesses that reduced their usefulness to the consumers they are
intended to help. Although these regulations likely were adequate when
card rates and terms were less complex, the disclosure materials they
produce for cards today, which have a multitude of terms and conditions
that can affect cardholders' costs, have proven difficult for consumers to
use in finding and understanding important information about their cards.
Although providing some key information, current disclosures also give
prominence to terms, such as minimum finance charge or balance computation
method, that are less significant to consumers' costs and do not
adequately emphasize terms such as those cardholder actions that could
cause their card issuer to raise their interest rate to a high default
rate. Because part of the reason that current disclosure materials may be
less effective is that they were designed in an era when card rates and
terms were less complex, the Federal Reserve also faces the challenge of
creating disclosure requirements that are more flexible to allow them to
be adjusted more quickly as new card features are introduced and others
become less common.

The Federal Reserve, which has adopted these regulations, has recognized
these problems, and its current review of the open-end credit rules of
Regulation Z presents an opportunity to improve the disclosures applicable
to credit cards. Based on our work, we believe that disclosures that are
simpler, better organized, and use designs and formats that comply with
best practices and industry standards for readability and usability would
be more effective. Our work and the experiences of other regulators also
confirmed that involving experts in readability and testing documents with
actual consumers can further improve any resulting disclosures. The
Federal Reserve has indicated that it has begun to involve consumers in
the design of new model disclosures, but it has not completed these
efforts to date, and new model disclosures are not expected to be issued
until 2007 or 2008. Federal Reserve staff noted that they recognize the
challenge of how best to incorporate the variety of information that
consumers may need to understand the costs of their cards in clear and
concise disclosure materials. Until such efforts are complete, consumers
will continue to face difficulties in using disclosure materials to better
understand and compare costs of credit cards. In addition, until more
understandable disclosures are issued, the ability of well-informed
consumers to spur additional competition among issuers in credit card
pricing is hampered.

Definitively determining the extent to which credit card penalty interest
and fees contribute to personal bankruptcies and the profits and revenues
of card issuers is difficult given the lack of comprehensive, publicly
available data. Penalty interest and fees can contribute to the total debt
owed by cardholders and decrease the funds that a cardholder could have
used to reduce debt and possibly avoid bankruptcy. However, many consumers
file for bankruptcy as the result of significant negative life events,
such as divorces, job losses, or health problems, and the role that credit
cards play in avoiding or accelerating such filings is not known.
Similarly, the limited available information on card issuer operations
indicates that penalty fees and interest are a small but growing part of
such firms' revenues. With the profitability of the largest card issuers
generally being stable over recent years, the increased revenues gained
from penalty interest and fees may be offsetting the generally lower
amounts of interest that card issuers collect from the majority of their
cardholders. These results appear to indicate that while most cardholders
likely are better off, a smaller number of cardholders paying penalty
interest and fees are accounting for more of issuer revenues than they did
in the past. This further emphasizes the importance of taking steps to
ensure that all cardholders receive disclosures that help them clearly
understand their card costs and how their own behavior can affect those
costs.

Recommendation for Executive Action

As part of its effort to increase the effectiveness of disclosure
materials used to inform consumers of rates, fees, and other terms that
affect the costs of using credit cards, the Chairman, Federal Reserve
should ensure that such disclosures, including model forms and formatting
requirements, more clearly emphasize those terms that can significantly
affect cardholder costs, such as the actions that can cause default or
other penalty pricing rates to be imposed.

Agency Comments and Our Evaluation

We provided a draft of this report to the Federal Reserve, OCC, FDIC, the
Federal Trade Commission, the National Credit Union Administration, and
the Office of Thrift Supervision for their review and comment. In a letter
from the Federal Reserve, the Director of the Division of Consumer and
Community Affairs agreed with the findings of our report that credit card
pricing has become more complex and that the disclosures required under
Regulation Z could be improved with the input of consumers. To this end,
the Director stated that the Board is conducting extensive consumer
testing to identify the most important information to consumers and how
disclosures can be simplified to reduce current complexity. Using this
information, the Director said that the Board would develop new model
disclosure forms with the assistance of design consultants. If
appropriate, the Director said the Board may develop suggestions for
statutory changes for congressional consideration.

We also received technical comments from the Federal Reserve and OCC,
which we have incorporated in this report as appropriate. FDIC, the
Federal Trade Commission, the National Credit Union Administration, and
the Office of Thrift Supervision did not provide comments.

As agreed with your offices, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after the date of this report. At that time, we will send copies of this
report to the Chairman, Permanent Subcommittee on Investigations, Senate
Committee on Homeland Security and Governmental Affairs; the Chairman,
FDIC; the Chairman, Federal Reserve; the Chairman, Federal Trade
Commission; the Chairman, National Credit Union Administration; the
Comptroller of the Currency; and the Director, Office of Thrift
Supervision and to interested congressional committees. We will also make
copies available to others upon request. The report will be available at
no charge on the GAO Web site at http://www.gao.gov .

If you or your staff have any questions regarding this report, please
contact me at (202) 512-8678 or [email protected] . Contact points for our
Offices of Congressional Relations and Public Affairs may be found on the
last page of this report. Key contributors to this report are listed in
appendix IV.

Sincerely yours,

David G. Wood Director, Financial Markets   and Community Investment

Appendix I

Objectives, Scope and Methodology

Our objectives were to determine (1) how the interest, fees, and other
practices that affect the pricing structure of cards from the largest U.S.
issuers have evolved, and cardholders' experiences under these pricing
structures in recent years; (2) how effectively the issuers disclose the
pricing structures of cards to their cardholders; (3) whether credit card
debt and penalty interest and fees contribute to cardholder bankruptcies;
and (4) the extent to which penalty interest and fees contribute to the
revenues and profitability of issuers' credit card operations.

Methodology for Identifying the Evolution of Pricing Structures

To identify how the pricing structure of cards from the largest U.S.
issuers has evolved, we analyzed disclosure documents from 2003 to 2005
for 28 popular cards that were issued by the six largest U.S. card
issuers, as measured by total outstanding receivables as of December 31,
2004 (see fig. 2 in the body of this report). These issuers were Bank of
America; Capital One Bank; Chase Bank USA, N.A.; Citibank (South Dakota),
N.A.; Discover Financial Services; and MBNA America Bank, N.A.
Representatives for these six issuers identified up to five of their most
popular cards and provided us actual disclosure materials, including
cardmember agreements and direct mail applications and solicitations used
for opening an account for each card. We calculated descriptive statistics
for various interest rates and fees and the frequency with which cards
featured other practices, such as methods for calculating finance charges.
We determined that these cards likely represented the pricing and terms
that applied to the majority of U.S. cardholders because the top six
issuers held almost 80 percent of consumer credit card debt and as much as
61 percent of total U.S. credit card accounts.

We did not include in our analysis of popular cards any cards offered by
credit card issuers that engage primarily in subprime lending. Subprime
lending generally refers to extending credit to borrowers who exhibit
characteristics indicating a significantly higher risk of default than
traditional bank lending customers. Such issuers could have pricing
structures and other terms significantly different to those of the popular
cards offered by the top issuers. As a result, our analysis may
underestimate the range of interest rate and fee levels charged on the
entire universe of cards. To identify historical rate and fee levels, we
primarily evaluated the Federal Reserve Board's G.19 Consumer Credit
statistical release for 1972 to 2005 and a paper written by a Federal
Reserve Bank
staff, which included more than 150 cardmember agreements from 15 of the
largest U.S. issuers in 1997 to 2002.1

To evaluate cardholders' experiences with credit card pricing structures
in recent years, we obtained proprietary data on the extent to which
issuers assessed various interest rate levels and fees for active accounts
from the six largest U.S. issuers listed above for 2003, 2004, and 2005.
We obtained data directly from issuers because no comprehensive sources
existed to show the extent to which U.S. cardholders were paying penalty
interest rates. Combined, these issuers reported more than 180 million
active accounts, or about 60 percent of total active accounts reported by
CardWeb.com, Inc. These accounts also represented almost $900 billion in
credit card purchases in 2005, according to these issuers. To preserve the
anonymity of the data, these issuers engaged legal counsel at the law firm
Latham & Watkins, LLP, to which they provided their data on interest rate
and fee assessments, which then engaged Argus Information and Advisory
Services, LLC, a third-party analytics firm, to aggregate the data, and
then supplied it to us. Although we originally provided a more
comprehensive data request to these issuers, we agreed to a more limited
request with issuer representatives as a result of these firms' data
availability and processing limitations. We discussed steps that were
taken to attempt to ensure that the data provided to us were complete and
accurate with representatives of these issuers and the third party
analytics firm. We also shared a draft of this report with the supervisory
agencies of these issuers. However, we did not have access to the issuers'
data systems to fully assess the reliability of the data or the systems
that housed them. Therefore, we present these data in our report only as
representations made to us by the six largest issuers.

Methodology for Assessing Effectiveness of Disclosures

To determine how effectively card issuers disclose to cardholders the
rates, fees, and other terms related to their credit cards, we contracted
with UserWorks, Inc., a private usability consulting firm, which conducted
three separate evaluations of a sample of disclosure materials. We
provided the usability consultant with a cardmember agreement and
solicitation letter for one card from four representative credit card
issuers-a total of four cards and eight disclosure documents. The first
evaluation, a readability assessment, used computer-facilitated formulas
to predict the grade level required to understand the materials.
Readability formulas measure the elements of writing that can be subjected
to mathematical calculation, such as average number of syllables in words
or numbers of words in sentences in the text. The consultant applied the
following industry-standard formulas to the documents: Flesch Grade Level,
Frequency of Gobbledygook (FOG), and the Simplified Measure of
Gobbledygook (SMOG). Using these formulas, the consultant measured the
grade levels at which the disclosure documents were written overall, as
well as for selected sections. Secondly, the usability consultant
conducted an heuristic evaluation that assessed how well these card
disclosure documents adhered to a recognized set of principles or industry
best practices. In the absence of best practices specifically applicable
to credit card disclosures, the consultant used guidelines from the U.S.
Securities and Exchange Commission's 1998 guidebook Plain English
Handbook: How to Create Clear SEC Disclosure Documents.

Finally, the usability consultant tested how well actual consumers were
able to use the documents to identify and understand information about
card fees and other practices and used the results to identify problem
areas. The consultant conducted these tests with 12 consumers.2 To ensure
sample diversity, the participants were selected to represent the
demographics of the U.S. adult population in terms of education, income,
and age. While the materials used for the readability and usability
assessments appeared to be typical of the large issuers' disclosures, the
results cannot be generalized to materials that were not reviewed.

To obtain additional information on consumers' level of awareness and
understanding of their key credit card terms, we also conducted in-depth,
structured interviews in December 2005 with a total of 112 adult
cardholders in three locations: Boston, Chicago, and San Francisco.3 We
contracted with OneWorld Communications, Inc., a market research
organization, to recruit a sample of cardholders that generally resembled
the demographic makeup of the U.S. population in terms of age, education
levels, and income. However, the cardholders recruited for the interviews
did not form a random, statistically representative sample of the U.S.
population and therefore cannot be generalized to the population of all
U.S. cardholders. Cardholders had to speak English, have owned at least
one general-purpose credit card for a minimum of 12 months, and have not
participated in more than one focus group or similar in-person study in
the 12 months prior to the interview. We gathered information about the
cardholders' knowledge of credit card terms and conditions, and assessed
cardholders' use of card disclosure materials by asking them a number of
open- and closed-ended questions.

Methodology for Determining How Penalty Charges Contribute to Bankruptcy

To determine whether credit card debt and penalty interest and fees
contribute to cardholder bankruptcies, we interviewed Department of
Justice staff responsible for overseeing bankruptcy courts and trustees
about the availability of data on credit card penalty charges in materials
submitted by consumers or issuers as part of bankruptcy filings or
collections cases. We also interviewed two attorneys that assist consumers
with bankruptcy filings. In addition, we reviewed studies that analyzed
credit card and bankruptcy issues published by various academic
researchers, the Congressional Research Service, and the Congressional
Budget Office. We did not attempt to assess the reliability of all of
these studies to the same, full extent. However, because of the prominence
of some of these data sources, and frequency of use of this data by other
researchers, as well as the fact that much of the evidence is corroborated
by other evidence, we determined that citing these studies was
appropriate.

We also analyzed aggregated card account data provided by the six largest
issuers (as previously discussed) to measure the amount of credit card
interest charges and fees owed at the time these accounts were charged off
as a result of becoming subject to bankruptcy filing. We also spoke with
representatives of the largest U.S. credit card issuers, as well as
representatives of consumer groups and industry associations, and with
academic researchers that conduct analysis on the credit card industry.

Methodology for Determining How Penalty Charges Contribute to Issuer
Revenues

To determine the extent to which penalty interest and fees contributed to
the revenues and profitability of issuers' credit card operations, we
reviewed the extent to which penalty charges are disclosed in bank
regulatory reports-the call reports-and in public disclosures-such as
annual reports (10-Ks) and quarterly reports (10-Qs) made by publicly
traded card issuers. We analyzed data reported by the Federal Reserve on
the profitability of commercial bank card issuers with at least $200
million in yearly average assets (loans to individuals plus
securitizations) and at least 50 percent of assets in consumer lending, of
which 90 percent must be in the form of revolving credit. In 2004, the
Federal Reserve reported that 17 banks had card operations with at least
this level of activity in 2004. We also analyzed information from the
Federal Deposit Insurance Corporation, which analyzes data for all
federally insured banks and savings institutions and publishes aggregated
data on those with various lending activity concentrations, including a
group of 33 banks that, as of December 2005, had credit card operations
that exceeded 50 percent of their total assets and securitized
receivables.

We also analyzed data reported to us by the six largest card issuers on
their revenues and profitability of their credit card operations for 2003,
2004, and 2005. We also reviewed data on revenues compiled by industry
analysis firms, including Card Industry Directory published by
Sourcemedia, and R.K. Hammer. Because of the proprietary nature of their
data, representatives for Sourcemedia and R.K. Hammer were not able to
provide us with information sufficient for us to assess the reliability of
their data. However, we analyzed and presented some information from these
sources because we were able to corroborate their information with each
other and with data from sources of known reliability, such as regulatory
data, and we attribute their data to them.

We also interviewed broker-dealer financial analysts who monitor
activities by credit card issuers to identify the extent to which various
sources of income contribute to card issuers' revenues and profitability.
We attempted to obtain the latest in a series of studies of card issuer
profitability that Visa, Inc. traditionally has compiled. However, staff
from this organization said that this report is no longer being made
publicly available.

We discussed issues relevant to this report with various organizations,
including representatives of 13 U.S. credit card issuers and card
networks, 2 trade associations, 4 academics, 4 federal bank agencies, 4
national consumer interest groups, 2 broker dealer analysts that study
credit card issuers for large investors, and a commercial credit-rating
agency. We also obtained technical comments on a draft of this report from
representatives of the issuers that supplied data for this study.

Appendix II

Consumer Bankruptcies Have Risen Along with Debt

Consumer bankruptcies have increased significantly over the past 25 years.
As shown in figure 21 below, consumer bankruptcy filings rose from about
287,000 in 1980 to more than 2 million as of December 31, 2005, about a
609 percent increase over the last 25 years.1

Figure 21: U.S. Consumer Bankruptcy Filings, 1980-2005

Debt Levels Have Also Risen

The expansion of consumers' overall indebtedness is one of the
explanations cited for the significant increase in bankruptcy filings. As
shown in figure 22, consumers' use of debt has expanded over the last 25
years, increasing more than 720 percent from about $1.4 trillion in 1980
to about $11.5 trillion in 2005.

Figure 22: U.S. Household Debt, 1980-2005

Some researchers have been commenting on the rise in overall indebtedness
as a contributor to the rise in bankruptcies for some time. For example,
in a 1997 congressional testimony, a Congressional Budget Office official
noted that the increase in consumer bankruptcy filings and the increase in
household indebtedness appeared to be correlated.2 Also, an academic paper
that summarized existing literature on bankruptcy found that some consumer
bankruptcies were either directly or indirectly caused by heavy consumer
indebtedness, specifically pointing to the high correlation between
consumer bankruptcies and consumer debt-to-income ratios.3

Beyond total debt, some researchers and others argue that the rise in
bankruptcies also was related to the rise in credit debt, in particular.
As shown in figure 23, the amount of credit card debt reported also has
risen from $237 billion to about $802 billion-a 238 percent increase
between 1990 and 2005.4

Figure 23: Credit Card and Other Revolving and Nonrevolving Debt
Outstanding, 1990 to 2005

Increased Access to Credit Cards by Lower-income Households Raised
Concerns

Rather than total credit card debt alone, some researchers argued that
growth in credit card use and indebtedness by lower-income households has
contributed to the rise in bankruptcies. In the survey of consumer
finances conducted every 3 years, the Federal Reserve reports on the use
and indebtedness on credit cards by households overall and also by income
percentiles. As shown in figure 24 below, the latest Federal Reserve
survey results indicated the greatest increase of families reporting
credit card debt occurred among those in the lowest 20 percent of
household income between 1998 and 2001.

Figure 24: Percent of Households Holding Credit Card Debt by Household
Income, 1998, 2001, and 2004

In the last 15 years, credit card companies have greatly expanded the
marketing of credit cards, including to households with lower incomes than
previously had been offered cards. An effort by credit card issuers to
expand its customer base in an increasingly competitive market
dramatically increased credit card solicitations. According to one study,
more than half of credit cards held by consumers are the result of
receiving
mail solicitations.5 According to another academic research paper, credit
card issuers have increased the number of mail solicitations they send to
consumers by more than five times since 1990, from 1.1 billion to 5.23
billion in 2004, or a little over 47 solicitations per household. The
research paper also found that wealthier families receive the highest
number of solicitations but that low-income families were more likely to
open them.6 As shown in figure 25 above, the Federal Reserve's survey
results indicated that the number of lower income households with credit
cards has also grown the most during 1998 to 2001, reflecting issuers'
willingness to grant greater access to credit cards to such households
than in the past.

Levels of Financial Distress Have Remained Stable among Households

The ability of households to make the payments on their debt appeared to
be keeping pace with their incomes as their total household debt burden
levels-which measure their payments required on their debts as percentage
of household incomes-have remained relatively constant since the 1980s. As
shown below in figure 25, Federal Reserve statistics show that the
aggregate debt burden ratio for U.S. households has generally fluctuated
between 10.77 percent to 13.89 percent between 1990 to 2005, which are
similar to the levels for this ratio that were observed during the 1980s.
Also shown in figure 25 are the Federal Reserve's statistics on the
household financial obligations ratio, which compares the total payments
that a household must make for mortgages, consumer debt, auto leases,
rent, homeowners insurance, and real estate taxes to its after-tax income.
Although this ratio has risen from around 16 percent in 1980 to over 18
percent in 2005-representing an approximately 13 percent increase-Federal
Reserve staff researchers indicated that it does not necessarily indicate
an increase in household financial stress because
much of this increase appeared to be the result of increased use of credit
cards for transactions and more households with cards.7

Figure 25: U.S. Household Debt Burden and Financial Obligations Ratios,
1980 to 2005

In addition, credit card debt remains a small portion of overall household
debt, including those with the lowest income levels. As shown in table 2,
credit card balances as a percentage of total household debt actually have
been declining since the 1990s.

Table 2: Portion of Credit Card Debt Held by Households

                                        

    Type of debt          1995 1998 2001 2004 
Amount of debt of all       
families, distributed       
by type of debt             
Secured home loan      80.7 78.9 81.4 83.7 
Lines of credit not     0.6  0.3  0.5  0.7 
secured by residential                     Installment 12.0 13.1 12.3 11.0 
property                                   loans                      
Credit card balances    3.9  3.9  3.4  3.0 
Other                   2.9  3.7  2.3  1.6 
Total                   100  100  100  100 

Source: Federal Reserve.

Also, as shown in table 3, median credit card balances for the
lowest-income households has remained stable from 1998 through 2004.

Table 3: Credit Card Debt Balances Held by Household Income8

                                        

                                                           1998   2001   2004 
    Median value of holdings for families holding credit 
card debt                                             
All families                                          $1,900 $2,000 $2,200 
Percentile of income                                                
Less than 20                                          $1,000 $1,100 $1,000 
20-39.9                                               $1,300 $1,300 $1,900 
40-59.9                                               $2,100 $2,100 $2,200 
60-79.9                                               $2,400 $2,400 $3,000 
80-89.9                                               $2,200 $4,000 $2,700 
90-100                                                $3,300 $3,000 $4,000 

Source: Federal Reserve.

As shown in figure 26 below, the number of households in the twentieth
percentile of income or less that reportedly were in financial distress
has remained relatively stable.

Figure 26: Households Reporting Financial Distress by Household Income,
1995 through 2004

As shown in figure 26 above, more lower-income households generally
reported being in financial distress than did other households in most of
the other higher-income groups. In addition, the lowest-income households
in the aggregate generally did not exhibit greater levels of distress over
the last 20 years, as the proportion of households that reported distress
was higher in the 1990s than in 2004.

Some Researchers Find Other Factors May Trigger Consumer Bankruptcies and
that Credit Cards Role Varied

Some academics, consumer advocacy groups, and others have indicated that
the rise in consumer bankruptcy filings has occurred because the normal
life events that reduce incomes or increase expenses for households have
more serious effects today. Events that can reduce household incomes
include job losses, pay cuts, or conversion of full-time positions to
part-time work. Medical emergencies can result in increased household
expenses and debts. Divorces can both reduce income and increase expenses.
One researcher explained that, while households have faced the same kinds
of risks for generations, the likelihood of these types of life events
occurring has increased. This researcher's studies noted that the
likelihood of job loss or financial distress arising from medical problems
and the risk of divorce have all increased. Furthermore, more households
send all adults into the workforce, and, while this increases their
income, it also doubles their total risk exposure, which increases their
likelihood of having to file for bankruptcy. According to this researcher,

about 94 percent of families who filed for bankruptcy would qualify as
middle class.9

Although many of the people who file for bankruptcy have considerable
credit card debt, those researchers that asserted that life events were
the primary explanation for filings noted that the role played by credit
cards varied. According to one of these researchers, individuals who have
filed for bankruptcy with outstanding credit card debt could be classified
into three groups:

o Those who had built up household debts, including substantial credit
card balances, but filed for bankruptcy after experiencing a life event
that adversely affected their expenses or incomes such that they could not
meet their obligations.

o Those who experienced a life event that adversely affected their
expenses or incomes, and increased their usage of credit cards to avoid
falling behind on other secured debt payments (such as mortgage debt), but
who ultimately failed to recover and filed for bankruptcy.

o Those with very little credit card debt who filed for bankruptcy when
they could no longer make payments on their secured debt. This represented
the smallest category of people filing for bankruptcy.

Appendix III

Factors Contributing to the Profitability of Credit Card Issuers

Various factors help to explain why banks that focus on credit card
lending generally have higher profitability than other lenders. The major
source of income for credit card issuers comes from interest they earn
from their cardholders who carry balances-that is, do not payoff the
entire outstanding balance when due. One factor that contributes to the
high profitability of credit card operations is that the average interest
rates charged on credit cards are generally higher than rates charged on
other types of lending. Rates charged on credit cards are generally the
highest because they are extensions of credit that are not secured by any
collateral from the borrower. Unlike credit cards, most other types of
consumer lending involve the extension of a fixed amount of credit under
fixed terms of repayment (i.e., the borrower must repay an established
amount of principal, plus interest each month) and are collateralized-such
as loans for cars, under which the lender can repossess the car in the
event the borrower does not make the scheduled loan payments. Similarly,
mortgage loans that allow borrowers to purchase homes are secured by the
underlying house. Loans with collateral and fixed repayment terms pose
less risk of loss, and thus lenders can charge less interest on such
loans. In contrast, credit card loans, which are unsecured, available to
large and heterogeneous populations, and can be repaid on flexible terms
at the cardholders' convenience, present greater risks and have
commensurately higher interest rates.

As shown in figure 27, data from the Federal Reserve shows that average
interest rates charged on credit cards were generally higher than interest
rates charged on car loans and personal loans. Similarly, average interest
rates charged on corporate loans are also generally lower than credit
cards, with the best business customers often paying the prime rate, which
averaged 6.19 percent during 2005.

Figure 27: Average Credit Card, Car Loans and Personal Loan Interest Rates

Moreover, many card issuers have increasingly begun setting the interest
rates they charge their cardholders using variable rates that change as a
specified market index rate, such as the prime rate, changes. This allows
credit card issuers' interest revenues to rise as their cost of funding
rises during times when market interest rates are increasing. Of the most
popular cards issued by the largest card issuers between 2004 and 2005
that we analyzed, more than 90 percent had variable rates that changed
according to an index rate. For example, the rate that the cardholder
would pay on these large issuer cards was determined by adding between 6
and 8 percent to the current prime rate, with a new rate being calculated
monthly.

As a result of the higher interest charges assessed on cards and variable
rate pricing, banks that focus on credit card lending had the highest net
interest margin compared with other types of lenders. The net interest
income of a bank is the difference between what it has earned on its
interest-bearing assets, including the balances on credit cards it has
issued and the amounts loaned out as part of any other lending activities,
and its interest expenses. To compare across banks, analysts calculate net
interest margins, which express each banks' net interest income as a
percentage of interest-bearing assets. The Federal Deposit Insurance
Corporation (FDIC) aggregates data for a group of all federally insured
banks that focus on credit card lending, which it defines as those with
more than 50 percent of managed assets engaged in credit card operations;
in 2005, FDIC identified 33 banks with at least this much credit card
lending activity. As shown in figure 28, the net interest margin of all
credit card banks, which averaged more than 8 percent, was about two to
three times as high as other consumer and mortgage lending activities in
2005. Five of the six largest issuers reported to us that their average
net interest margin in 2005 was even higher, at 9 percent.

Figure 28: Net Interest Margin for Credit Card Issuers and Other Consumer
Lenders in 2005

Credit Card Operations Also Have Higher Rates of Loan Losses and Operating
Expenses

Although profitable, credit card operations generally experience higher
charge-off rates and operating expenses than those of other types of
lending. Because these loans are generally unsecured, meaning the borrower
will not generally immediately lose an asset-such as a car or house-if
payments are not made, borrowers may be more likely to cease making
payments on their credit cards if they become financially distressed than
they would for other types of credit. As a result, the rate of losses that
credit card issuers experience on credit cards is higher than that
incurred on other types of credit. Under bank regulatory accounting
practices, banks must write off the principal balance outstanding on any
loan when it is determined that the bank is unlikely to collect on the
debt. For credit cards, this means that banks must deduct, as a loan loss
from their income, the amount of balance outstanding on any credit card
accounts for which either no payments have been made within the last 180
days or the bank has received notice that the cardholder has filed for
bankruptcy. This procedure is called charging the debt off. Card issuers
have much higher charge-off rates compared to other consumer lending
businesses as shown in figure 29.

Figure 29: Charge-off Rates for Credit Card and Other Consumer Lenders,
2004 to 2005

The largest credit card issuers also reported similarly high charge-off
rates for their credit card operations. As shown in figure 30, five of the
top six credit card issuers that we obtained data from reported that their
average charge-off rate was higher than 5.5 percent between 2003 and 2005,
well above other consumer lenders' average net charge-off rate of 1.44
percent.

Figure 30: Charge-off Rates for the Top 5 Credit Card Issuers, 2003 to
2005

Credit card issuers also incur higher operating expenses compared with
other consumer lenders. Operating expense is another one of the largest
cost items for card issuers and, according to a credit card industry
research firm, accounts for approximately 37 percent of total expenses in
2005. The operating expenses of a credit card issuer include staffing and
the information technology costs that are incurred to maintain
cardholders' accounts. Operating expense as a proportion of total assets
for credit card lending is higher because offering credit cards often
involves various activities that other lending activities do not. For
example, issuers often incur significant expenses in postage and other
marketing costs as part of soliciting new customers. In addition, some
credit cards now provide rewards and loyalty programs that allow
cardholders to earn rewards such as free airline tickets, discounts on
merchandise, or cash back on their accounts, which are not generally
expenses associated with other types of lending. Credit card operating
expense burden also may be higher because issuers must service a large
number of relatively small accounts. For example, the six large card
issuers that we surveyed reported that they each had an average of 30
million credit card accounts, the average outstanding balance on these
accounts was about $2,500, and 48 percent of accounts did not revolve
balances in 2005.

As a result, the average operating expense, as a percentage of total
assets for banks, that focus on credit card lending averaged over 9
percent in 2005, as shown in figure 31, which was well above the 3.44
percent average for other consumer lenders. The largest issuers operating
expenses may not be as high as all banks that focus on credit card lending
because their larger operations give them some cost advantages from
economies of scale. For example, they may be able to pay lower postage
rates by being able to segregate the mailings of account statements to
their cardholders by zip code, thus qualifying for bulk-rate discounts.

Figure 31: Operating Expense as Percentage of Total Assets for Various
Types of Lenders in 2005

Another reason that the banks that issue credit cards are more profitable
than other types of lenders is that they earn greater percentage of
revenues from noninterest sources, including fees, than lenders that focus
more on other types of consumer lending. As shown in figure 32, FDIC data
indicates that the ratio of noninterest revenues to assets-an indicator of
noninterest income generated from outstanding credit loans-is about 10
percent for the banks that focus on credit card lending, compared with
less than 2.8 percent for other lenders.

Figure 32: Non-Interest Revenue as Percentage of Their Assets for Card
Lenders and Other Consumer Lenders

Effect of Penalty Interest and Fees on Credit Card Issuer Profitability

Although penalty interest and fees apparently have increased, their effect
on issuer profitability may not be as great as other factors. For example,
while more cardholders appeared to be paying default rates of interest on
their cards, issuers have not been experiencing greater profitability from
interest revenues. According to our analysis of FDIC Quarterly Banking
Profile data, the revenues that credit card issuers earn from interest
generally have been stable over the last 18 years.1 As shown in figure 33,
net interest margin for all banks that focused on credit card lending has
ranged between 7.4 percent and 9.6 percent since 1987. Similarly,
according to the data that five of the top six issuers provided to us,
their net interest margins have been relatively stable between 2003 and
2005, ranging from 9.2 percent to 9.6 percent during this period.

Figure 33: Net Interest Margin for All Banks Focusing on Credit Card
Lending, 1987-2005

These data suggest that increases in penalty interest assessments could be
offsetting decreases in interest revenues from other cardholders. During
the last few years, card issuers have competed vigorously for market
share. In doing so, they frequently have offered cards to new cardholders
that feature low interest rates-including zero percent for temporary
introductory periods, usually 8 months-either for purchases or sometimes
for balances transferred from other cards. The extent to which cardholders
now are paying such rates is not known, but the six largest issuers
reported to us that the proportion of their cardholders paying interest
rates below 5 percent-which could be cardholders enjoying temporarily low
introductory rates-represented about 7 percent of their cardholders
between 2003 and 2005. To the extent that card issuers have been receiving
lower interest as the result of these marketing efforts, such declines
could be masking the effect of increasing amounts of penalty interest on
their overall interest revenues.

Although revenues from penalty fees have grown, their effect on overall
issuer profitability is less than the effect of income from interest or
other factors. For example, we obtained information from a Federal Reserve
Bank researcher with data from one of the credit card industry surveys
that illustrated that the issuers' cost of funds may be a more significant
factor for their profitability lately. Banks generally obtain the funds
they use to lend to others through their operations from various sources,
such as checking or savings deposits, income on other investments, or
borrowing from other banks or creditors. The average rate of interest they
pay on these funding sources represents their cost of funds. As shown in
table 4 below, the total cost of funds (for $100 in credit card balances
outstanding) for the credit card banks included in this survey declined
from $8.98 in 1990 to a low of $2.00 in 2004-a decrease of 78 percent.
Because card issuers' net interest income generally represents a much
higher percentage of revenues than does income from penalty fees, its
impact on issuers' overall profitability is greater; thus the reduction in
the cost of funds likely contributed significantly to the general rise in
credit card banks' profitability over this time.

Table 4: Revenues and Profits of Credit Card Issuers in Card Industry
Directory per $100 of Credit Card Assets

                                        

         Revenues and profits              1990       2004     Percent change 
Interest revenues                     $16.42     $12.45               -24% 
Cost of funds                           8.98       2.00                -78 
Net interest income                     7.44      10.45                 40 
Interchange fee revenues                2.15       2.87                 33 
Penalty fee revenues                    0.69       1.40                103 
Annual fee revenues                     1.25       0.42                -66 
Other revenues                          0.18       0.87                383 
Total revenue from operations          11.71      16.01                 37 
Other expenses                          8.17      10.41                 27 
Taxes                                   1.23       1.99                 62 
Net income                              2.30       3.61                 57 

Source: GAO Analysis of Card Industry Directory data.

Although card issuer revenues from penalty fees have been increasing since
the 1980s, they remain a small portion of overall revenues. As shown in
table 4 above, our analysis of the card issuer data obtained from the
Federal Reserve indicated that the amount of revenues that issuers
collected from penalty fees for every $100 in credit card balances
outstanding climbed from 69 cents to $1.40 between 1990 and 2004-an
increase of 103 percent. During this same period, net interest income
collected per $100 in card balances outstanding grew from $7.44 to
$10.45-an increase of about 41 percent. However, the relative size of each
of these two sources of income indicates that interest income is between 7
to 8 times more important to issuer revenues than penalty fee income is in
2004. Furthermore, during this same time, collections of annual fees from
cardholders declined from $1.25 to 42 cents per every $100 in card
balances-which means that the total of annual and penalty fees in 2004 is
about the same as in 1990 and that this decline may also be offsetting the
increased revenues from penalty fees.

Appendix IV

Comments from the Federal Reserve Board

Appendix V

GAO Contact and Staff Acknowledgments

GAO Contact
Dave Wood (202) 512-8678

Staff Acknowledgments

In addition to those named above, Cody Goebel, Assistant Director; Jon
Altshul; Rachel DeMarcus; Kate Magdelena Gonzalez; Christine Houle;
Christine Kuduk; Marc Molino; Akiko Ohnuma; Carl Ramirez; Omyra Ramsingh;
Barbara Roesmann; Kathryn Supinski; Richard Vagnoni; Anita Visser; and
Monica Wolford made key contributions to this report.

(250248)

www.gao.gov/cgi-bin/getrpt? GAO-06-929 .

To view the full product, including the scope
and methodology, click on the link above.

For more information, contact David G. Wood at (202) 512-8678 or
[email protected].

Highlights of GAO-06-929 , a report to the Ranking Minority Member,
Permanent Subcommittee on Investigations, Committee on Homeland Security
and Governmental Affairs, U.S. Senate

September 2006

CREDIT CARDS

Increased Complexity in Rates and Fees Heightens Need for More Effective
Disclosures to Consumers

With credit card penalty rates and fees now common, the Federal Reserve
has begun efforts to revise disclosures to better inform consumers of
these costs. Questions have also been raised about the relationship among
penalty charges, consumer bankruptcies, and issuer profits. GAO examined
(1) how card fees and other practices have evolved and how cardholders
have been affected, (2) how effectively these pricing practices are
disclosed to cardholders, (3) the extent to which penalty charges
contribute to cardholder bankruptcies, and (4) card issuers' revenues and
profitability. Among other things, GAO analyzed disclosures from popular
cards; obtained data on rates and fees paid on cardholder accounts from 6
large issuers; employed a usability consultant to analyze and test
disclosures; interviewed a sample of consumers selected to represent a
range of education and income levels; and analyzed academic and regulatory
studies on bankruptcy and card issuer revenues.

What GAO Recommends

As part of revising card disclosures, the Federal Reserve should ensure
that such disclosure materials more clearly emphasize those terms that can
significantly affect cardholder costs, such as the actions that can cause
default or other penalty pricing rates to be imposed. The Federal Reserve
generally concurred with the report.

Originally having fixed interest rates around 20 percent and few fees,
popular credit cards now feature a variety of interest rates and other
fees, including penalties for making late payments that have increased to
as high as $39 per occurrence and interest rates of over 30 percent for
cardholders who pay late or exceed a credit limit. Issuers explained that
these practices represent risk-based pricing that allows them to offer
cards with lower costs to less risky cardholders while providing cards to
riskier consumers who might otherwise be unable to obtain such credit.
Although costs can vary significantly, many cardholders now appear to have
cards with lower interest rates than those offered in the past; data from
the top six issuers reported to GAO indicate that, in 2005, about 80
percent of their accounts were assessed interest rates of less than 20
percent, with over 40 percent having rates below 15 percent. The issuers
also reported that 35 percent of their active U.S. accounts were assessed
late fees and 13 percent were assessed over-limit fees in 2005.

Although issuers must disclose information intended to help consumers
compare card costs, disclosures by the largest issuers have various
weaknesses that reduced consumers' ability to use and understand them.
According to a usability expert's review, disclosures from the largest
credit card issuers were often written well above the eighth-grade level
at which about half of U.S. adults read. Contrary to usability and
readability best practices, the disclosures buried important information
in text, failed to group and label related material, and used small
typefaces. Perhaps as a result, cardholders that the expert tested often
had difficulty using the disclosures to find and understand key rates or
terms applicable to the cards. Similarly, GAO's interviews with 112
cardholders indicated that many failed to understand key aspects of their
cards, including when they would be charged for late payments or what
actions could cause issuers to raise rates. These weaknesses may arise
from issuers drafting disclosures to avoid lawsuits, and from federal
regulations that highlight less relevant information and are not well
suited for presenting the complex rates or terms that cards currently
feature. Although the Federal Reserve has started to obtain consumer
input, its staff recognizes the challenge of designing disclosures that
include all key information in a clear manner.

Although penalty charges reduce the funds available to repay cardholders'
debts, their role in contributing to bankruptcies was not clear. The six
largest issuers reported that unpaid interest and fees represented about
10 percent of the balances owed by bankrupt cardholders, but were unable
to provide data on penalty charges these cardholders paid prior to filing
for bankruptcy. Although revenues from penalty interest and fees have
increased, profits of the largest issuers have been stable in recent
years. GAO analysis indicates that while the majority of issuer revenues
came from interest charges, the portion attributable to penalty rates has
grown.

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