Tuesday, February 23, 2010

New credit card rules

Yesterday the new legislation affecting credit cards went into effect. While one can argue the merits of some government intervention, there are a couple parts of the legislation that I think are good ideas. "Nudges" as Thaler and Sunstein would call them.

The best example of a nudge in the current legislation is that your credit card statement will now be required to display this:

4. Minimum payment warning
Estimate of how long it could take to pay off your balance if you make only the minimum payment each month, and how much you’ll have to pay to eliminate your balance in three years.

Consumers should know how to figure out how much more they're paying for their loan if they're only making the minimum payments, but most probably don't take the time to figure it out. The credit card company counts on consumers not doing the math because that's how they make more money. Now, the company is required to do the math for you and put it front and center.

Students are always disturbed to see how much more they're paying for things if they're making the minimum payment. They sometimes think they're just being good citizens by making that minimum payment, but don't figure out how it all adds up.

An in-class example:
Suppose you put $500 of textbooks on your credit card. The card advertises a 19% rate and the monthly payments it requires on the balance is $20. How long will it take to pay off your books? How much will you have paid for them?

The answer is 32 months, almost 3 years! The total amount paid then comes out to $20 x 32 months = $640. You paid $140 more for the already expensive books.

The credit card companies are now required to do the above math for you.

Suppose you developed a plan to pay off your books in 12 months. How much does your payment need to be? The answer here is $46.08. In the end, you will still have paid $46.08 x 12 = $552.96 for your textbooks. $53 is better than $140, but it's still money that would be better spent elsewhere.

The alternative? Start saving $46 every month (or as much as you can) a year in advance so that you can buy your textbooks with cash. That way you don't pay more than the price tag.

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