Judging by the average credit card interest rates published by Bankrate.com, one could rather easily come under the impression that credit card interest rates have been relatively stable throughout the past two years. The startling truth is that, on a relative basis, they have skyrocketed. This is not due to any fault in Bankrate’s average. In fact, Bankrate’s average rate formula is as good as it gets. The real reason credit card interest rates are at nosebleed heights is that, unlike the Prime Rate most variable rates are based on, credit card rates have stayed flat or increased during the past two years, while the Prime Rate has dropped to historical lows.
To get a good sense of just how high variable credit card interest rates are today, it is important to understand the formula that determines how much credit card companies charge in interest. This simple equation is the Prime Rate plus X. In 2007, the prime rate ranged from 8.25% to 7.25%. During that year, average credit card interest rates were essentially the same as they are today, with low rate cards in the 12% range. At that time, the X in the variable rate formula was about 4.5%.
Today the Prime Rate stands at 3.25% and low credit card rates remain in the 12% range. Thus, while one factor in the credit card rate equation has dropped by over 40%, the X factor has essentially doubled. If credit card companies had maintained the same pricing models used in 2007, average interest rates would be around 8%, providing a welcome relief to consumers struggling to pay down excessive debt. Instead, most credit card companies have doubled the X factor and credit card rate formulas are now increasingly based on the Prime Rate + 8%. And that’s for consumers with excellent credit. People with good and average credit are likely paying Prime +12% or more.
When the economy starts to improve, the Federal Reserve will be under pressure to increase the Fed Funds Rate upon which the Prime Rate is based. While it may take years for the Prime Rate to return to historical median of 8.75%, if it were to return to the 2007 high of 8.25%, average credit card interest rates for people with excellent credit will skyrocket to more than 16%. Consumers with good credit will likely face rates in excess of 20% and those on the fringe will see 30% interest rates.
Any consumer carrying credit card debt today who has the ability to reduce their credit card balances needs to do so as soon as possible. 0% balance transfers are an effective tool to reduce current interest expenses and overall debt loads, but 0% interest rates are temporary and may likely be less common in the coming months. Utilizing a 0% credit card will help interest expenses from mounting, but tools like these must be combined with a concerted effort to get out of credit card debt as soon as possible. Why? Because what seem like high rates today will look like sweetheart deals when the Prime Rate returns to its historical mean, and consumers carrying credit card debt will find themselves caught in spiraling debt traps.
-Jeffrey Weber
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