Can Credit Card Interest Rates be Capped?

The American politics is heating up in anticipation of the 2020 Presidential Election. Democrats are unveiling what appears to be a populist socialistic agenda. Amongst the Democrats, Bernie Sanders, in particular, is hell-bent on enacting policies which can be considered to be socialist. Bernie Sanders has found an ally in Alexandria Ocasio-Cortez as she too shares his viewpoint.

Both Ocasio-Cortez and Sanders have introduced legislation which tries to cap the interest rates being charged by credit card companies at 15%.

Financial analysts do not think that this proposal would become a reality as long as Donald Trump is in power. This is because, in 2018, credit card companies earned over $113 billion in fees and interest combined.

Trump, being a capitalist, would not want to change that. However, they do believe that this issue could become a major talking point for the 2020 elections since close to 90% of the consumers are unhappy about the high-interest rates which are charged to them on credit cards.

In this article, we will have a critical look at the proposal floated by Bernie Sanders and Alexandria Ocasio Cortez.

The Current Interest Rate Situation

The Democrats are of the opinion that the interest rates being charged by banks, credit card companies and payday loans are simply horrendous. This is because these companies themselves borrow money from the Federal Reserve at about 2% interest. However, when they lend the same money to the consumers, they charge an average of 17% interest rate to all consumers. This is the average interest rate when all consumers are considered (prime and subprime). The interest rates for subprime consumers are in the range of 24% per annum!

The Democrats claim that this is usury and must be stopped. They also claim that capping of interest rates is nothing new and has been traditionally done in America. It is only recently that the banks have used corruption and lobbying to change the rules, which now allows them to have a free run while charging interest.

This is the reason why Sanders and Ocasio-Cortez want to create a system wherein the federal government will make it illegal to charge more than 15% interest in America. Also, the individual state governments will have the right to reduce this interest rate further.

Why do Credit Card Companies Charge High-Interest Rates?

To understand whether the measures proposed by the Democrats will be successful, we first need to understand why credit card companies charge such high-interest rates in the first place.

It would be incorrect to say that the credit card companies have formed a cartel and are not allowing the interest rates to be lowered. If that is the case, then America must use its anti-trust laws to break up these companies.

However, the creation of a worldwide cartel is impossible since there are many players in this game, and all of them charge high-interest rates. It is, therefore, likely that the cost of giving out credit cards is inherently high. This is not hard to believe since credit card loans are basically unsecured and the customers could also claim bankruptcy.

Hence, there will always be a certain percentage of loans which will not be paid back. Higher interest rates are therefore required to offset the risk of defaults and enable the businesses to make money still.

What will Happen if the Plan is Implemented?

It is important to understand that the proposal being floated by the Democrats may sound good on moral grounds. However, the reality is that there is very little economic backing to their idea. Some of the economic criticisms have been listed below:

  • Credit Shortage: The forced ceiling on the interest rates would work as a price ceiling. Economists around the world know that when price ceilings are imposed, the obvious repercussions are shortages and black marketing. This same story is likely to repeat itself in the credit markets as well.

    If the artificial interest rate ceiling is imposed, banks will no longer find it viable to lend to subprime borrowers. They will only issue credit cards to prime borrowers. All the cards and loans outstanding to subprime borrowers will be called in. This would lead to a wave of defaults.

    Also, since the subprime borrowers will have an unmet need, they will have to resort to illegal moneylenders. The law will make money lending even more expensive, and the policy will end up hurting the very people it was meant to protect. Also, this law will create a syndicate of dangerous and violent loan sharks almost overnight.

  • Post Office Bankruptcy: Sanders and Ocasio Cortez have suggested that the United States Post Office should be utilized to provide short term payday loans to poor Americans. This is an absurd suggestion by any means.

    The post office is already struggling financially. Converting it into the biggest sub-prime lender overnight will only worsen its problems and make its path to bankruptcy shorter.

  • Economic Downturn: It is important to realize that a lot of purchases are made with credit cards. Hence, if a large number of people suddenly did not have credit cards, the economy will slow down considerably.

    Fixing a ceiling on the interest rate being charged will force the banks to withdraw their existing credit cards. This will reduce the purchasing power of the people and end up having a negative effect on the economy in general.

The bottom line is that the proposal to cap the interest rates is actually a Trojan horse. It may seem like the morally correct thing to do. However, it is the economically incorrect step to take if the problem actually needs to be solved.

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