The noose around credit card holders may tighten after the Fed hikes rates. May 25, 2004: 11:24 AM EDT
By Jeanne Sahadi, CNN/Money senior writer
NEW YORK (CNN/Money) – The closest I'm guessing most Americans would ever want to get to a mob boss is watching "The Sopranos."
Seriously. Imagine taking a loan from a kingpin of organized crime. Forget about getting whacked. The interest alone will kill you.
But as a people we're not shy about hooking up with lenders who charge exorbitant rates.
Take our love affair with plastic. Granted, credit card issuers are in business to make a profit for providing consumers with extended loans and other services.
But charging a penalty interest rate of 30 percent or more on cardholders who miss payments, exceed credit limits, or in some other way default?
That's what industry research firm CardWeb.com projects will be the case for some card issuers after the Fed starts raising interest rates, which it is widely expected to begin doing this summer. As it is, only one of the top 10 issuers -- Providian -- is practically there already, charging a penalty rate of 29.99 percent.
A penalty rate (or default rate) replaces your regular annual percentage rate (APR) when your account is perceived to be in default and may stay in effect for as long as the issuer wants.
Penalty rates typically are variable and pegged to the prime rate (for example, a lender will establish a formula, such as prime + x percent). When the Fed hikes its target for the overnight lending rate between banks, the prime rate, which is the rate banks give to their most creditworthy customers, also goes up.
Likewise, lenders often use the prime rate as a baseline to establish the standard APR – that which is charged on balances that are carried rather than paid off. The average APR has trended between 14 percent and 16 percent in recent years. But penalty rates typically have been much higher.
Currently, the average penalty rate is 25.88 percent, up from 23.26 percent in 2001, according to CardWeb.com.
The risk for card holders isn't just rising rates. In many cases, the definition of "default," which would trigger a penalty rate, has broadened to include late payments on accounts with creditors other than your credit card issuer, assuming those late payments show up on your credit report and ding your credit score. (Typically, that may not happen unless you're late by two billing cycles.)
And often, "a FICO credit score below 600 will trigger a universal default clause," said CardWeb.com CEO Robert McKinley in an email exchange.
So if you're up to date with your credit card payments – meaning you pay at least the minimum on time, if not more -- but you miss a payment with another lender and it shows up on your credit report, you still may get slammed with a penalty rate on your credit card.
Sheesh. Even the Mafia doesn't take it that far.
So, where does that leave you? In a tough spot if you're not paying attention.
If you pay off your balance in full every month, the rate isn't a concern because you avoid interest charges. But you'll still want to avoid those rising late fees. The average now charged by the top 10 issuers is $36.50, up from $29.60 in 2001.
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But if you have a balance, you have to be vigilant about not giving your card issuer any reason to impose the penalty rate either before or after the Fed makes a move.
After all, say you're carrying a $10,000 balance: a hike of 14 percentage points (say, from a 16 percent standard APR to a 30 percent variable default rate) can cost you over $1,000 a year extra in minimum payments alone, McKinley noted.
So pay at least the minimum owed on time every month for all of your credit accounts and loans.
Remember, too, that grace periods for credit cards – the time you have between the end of the billing cycle and when you have to pay up -- have gotten shorter.
So keep track of when your issuer expects to be paid, including the time of day, since many issuers now specify the hour when they have to have your money in hand before assessing a late fee.
Don't get me wrong. Credit cards can be a great tool. But once you start carrying a balance, you potentially forfeit a lot of control over your financial well-being.
When it comes to the terms on plastic, McKinley said, "issuers hold all the cards."
Jeanne Sahadi writes about personal finance for CNN/Money. She also appears regularly on CNNfn's "Your Money," which airs weeknights at 5 p.m. ET. You can e-mail her at email@example.com.