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The new credit card rules, which have been phased in over the past year, were intended to put important new consumer protections in place. A hallmark of the new law was its ban on retroactive interest rates hikes on existing credit card balances. This important new protection was intended to give consumers taking on credit card debt more certainty around what interest rates they would be paying on the debt. (Card issuers can still increase interest rates on future charges, as long as they give the cardholder 45 days notice and the right to opt out.)
Unfortunately, despite the new credit card protections, consumers with outstanding credit card debt may well be set for a considerable upward climb in interest rates, even on existing balances. A combination of macro-economic forces and changes to credit cards, which card issuers put into place before the new laws became effective, conspire to put consumers back to square one, holding the short end of the stick.
Prior to the implementation of the new credit card law, card issuers changed the terms on most credit cards, turning fixed rate credit cards into variable rate cards. While the interest rate on fixed-rate cards, as the name implies, stays steady (unless a cardholder defaults on payments for more than 60 days), variable rate cards are tied to an underlying index (typically the U.S. prime rate), and fluctuate with this rate. The effective interest rate on variable rate credit cards is derived by adding a fixed percentage (the margin) to the underlying index. While the new credit card law requires credit card issuers to maintain a set margin, the other half of the variable APR, the prime rate, will fluctuate with the Fed funds rate (the prime rate is derived by adding 3 percent to the Fed funds rate). In short, for variable rate credit cards interest rates will go up or down, in tune with the prime rate, even on existing credit card debt.
This is bad news for anyone struggling with credit card debt. Why? Because the prime rate is at historic lows, and economists predict that interest rates are set for an upward climb. The prolonged economic downturn, the burgeoning national debt, and the increasing risk of rampant inflation all conspire to push interest rates higher. The Fed has been holding the Fed funds rate at record lows to help stimulate the ailing economy. However, sooner or later the Fed will have to begin to raise the rate, and interest rates will begin to climb.
Already in the past two years, even with the prime rate at historic lows, the average credit card interest rate has begun to creep up, as banks have gradually increased rates to shore up risk. Experts predict that by the end of this year, the average credit card APR will have climbed as high as 17 percent.
Once the prime rate begins to climb, this will add further pressure to credit card interest rates. Less than four years ago, in June of 2006, the prime rate stood at 8.25 percent, five percent higher than today. For the average credit cardholder, that would mean a five-percent increase in interest.
How high can interest rates go? About thirty years ago, in December of 1980, the U.S. prime rate peaked at 21.50, 18.25 percent higher than its current level. For variable cardholders, add 18.25 percent to your current interest, and you will have your all-time worst credit card nightmare (and mortgage nightmare as well, for ARM holders).
Of course, it is unlikely that the country will return to the extreme inflationary environment and record interest rates of the 1980s. Still, it’s a sobering reminder of just how volatile interest rates tied to the prime rate can be.
For cardholders, the prospect of rising interest rates is a reminder that, more than ever, it’s important to stay clear of credit card debt, which remains the most unpredictable of all types of consumer debt. To avoid getting trapped paying sky-high interest rates on credit card debt, minimize credit card spending and look for ways to pay off credit card debt faster.
