Down with Default Rates!

by Odysseas Papadimitriou on October 5, 2011

penalty aprIn a previous article, I made the case that usury laws are counter-productive. Usury laws, which cap interest rates for lenders, completely fail to serve their intended purpose of forcing banks to deliver affordable loans and instead result in the declining availability of loans for anyone whose credit history merits an interest rate above an arbitrary cap. While this is still true for regular interest rates, I would like to suggest one particular feature of our contemporary lending industry that could actually benefit from usury laws: Penalty rates.

Why? Because penalty (or default) rates on loans and credit cards currently dictate the order in which consumers repay their debt obligations during times of crisis and invite banks to engage in reverse competition over who can charge the highest interest rates.

When you are first looking for a loan or credit card, issuers are incentivized to compete with each other because the company offering the best terms will likely win your business. The lucrative initial rewards bonuses, 0% offers and low regular interest rates that we’ve seen recently are prime examples of this. Banks want to add to their portfolios those consumers who managed to maintain excellent credit during the Great Recession and are playing a game of one-upmanship to get them.

However, when you get into financial trouble and are forced to make choices about which loans you can afford to pay back, this competition works against you. As you are likely to pay back the lender with the highest interest rate first, lenders are motivated to raise their rates as high as possible when you’re having trouble paying your bills. Thus, your monthly dilemma about whom to pay will be based on increasingly dire alternatives as lenders strive to be your biggest burden.

Congress could end this unhealthy competition simply by capping default interest rates as a function of the Prime Rate. In other words, when the Prime Rate goes down, the default interest rate will also go down and vice versa. A ceiling for these rates would ensure that reverse competition could only go so far and that a consumer’s struggles would not spiral out of control. This would, of course, relieve some of the pressure currently on those people who have lost their jobs over the last few years as well as the vast majority of us who from time to time struggle to make ends meet.

Besides, isn’t the overarching philosophical goal of usury laws to help the little guy? Sure, limiting default rates would limit banks’ earning potential, but it would also ensure that one’s your unpaid bills don’t snow ball through escalating default interest rates. After all, fair is fair and we should have to pay more if we don’t live up to our end of a credit agreement, but taking a beating for something that may only merit a slap on the wrist isn’t right.

[Disclosure: Some of the links within this article point to Card Hub, which is owned by the same parent company as Wallet Blog.]

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