The Hidden Costs of Capping Credit Card Interest Rates

A rate cap could leave millions scrambling for alternatives in an increasingly cashless economy.

Interest rates on credit cards have been unusually high for a while and have become an occasional target of politicians. In 2020, during Kamala Harris' first presidential campaign, she proposed forbidding credit card companies from charging interest altogether during the pandemic. In September this year, during a campaign rally in New York, Donald Trump proposed capping credit card interest rates at 10 percent. Others from Josh Hawley to Bernie Sanders have also taken up the cause.

Lost in these proposals are millions of Americans who may lose their credit card overnight—not because they mismanaged their finances, but because a new policy made it unprofitable for lenders to offer credit. Many borrowers, even those with good credit scores, could see their accounts terminated under an interest rate cap, leaving them scrambling for alternatives in a society that often requires a credit card to function.

The current average credit card interest rate is 21 percent, but it didn't get there overnight. In 2008, the average rate was 14 percent, at a time when the savings rate was much lower and consumers were overextended. In 2009, a Democratic supermajority in Congress passed the CARD Act, bringing a bevy of new regulations for credit card companies, such as requiring advance notice of any rate increases and limitations on fees for late payments.

Interest rates began rising immediately following the passage of the CARD Act and continued to rise as the risk-free rate—the Federal Reserve's overnight lending rate, currently about 4.75 percent—fell to 0 percent throughout most of the 2010s. Objectively, credit card interest rates are high today, but they are arguably high as a direct result of legislation passed at the end of the 2000s. Capping credit card interest rates is simply an intervention to correct the results of previous interventions.

There is a reason that credit cards carry a higher average interest rate than mortgages (7 percent) or car loans (8 percent). Mortgages and car loans are secured lending—the bank has collateral in the event of a default which increases recovery rates. Credit card borrowing is unsecured lending—lenders rely on nothing more than trust in the borrower. When losses occur, they are total and catastrophic. Credit card lending is inherently risky. 

The vast majority of borrowers are unprofitable at a 10 percent interest rate. If credit card interest rates were capped at 10 percent, it wouldn't just disrupt individual finances—it could destabilize the entire credit system. Major credit card lenders, such as Capital One Financial, would likely terminate the accounts of millions of their less creditworthy customers, which could mean anyone with a credit score of 780 or lower. To the extent possible, they might introduce new fees to make up for the loss of interest revenue, but the Consumer Financial Protection Bureau is already taking a hard look at late fees, which can be large relative to small credit card balances. 

Customers who lose access to credit would have to resort to cash or debit cards—and find that it is hard to function in modern society without a credit card. Even renting a car or getting a hotel room are activities that require a credit card. The Dave Ramseys of the world tell sad stories of people who are drowning in credit card debt; they don't tell the stories of the people who use that credit to accomplish financial goals, get higher-paying jobs, and grow out of the debt, and eventually, paying it back.

Consumers have gotten a lot smarter about credit cards over the years by checking their balances frequently (unlike in the '90s when you had to wait to receive a paper bill at the end of the month) and learning ways to improve their credit scores. The average credit score has increased from 689 in 2010 to 715 today. The overall growth of consumer credit has slowed in recent years, suggesting that lowering credit card rates by fiat would actually increase the use of credit, resulting in more indebtedness. Capping credit card rates would be a lot like cutting the nicotine content of cigarettes—people would simply smoke more cigarettes.

Interest rates are prices—the price of money—and all prices are signals. Capping credit card rates might sound like a win for consumers, but in practice, it's a lesson in unintended consequences. Policymakers must tread carefully, weighing the broader economic impacts before introducing well-intentioned but potentially devastating reforms.