Credits, Debits, and CodeHow Credit Cards Work — Line-Item-Level Interest Policies
Did you know that there are several completely different ways that credit card and bundled Buy Now Pay Later companies calculate interest?
They each have their uses, but work very differently.
Let’s take a look at two different ways to calculate interest:
The first is to offer cards with account-level interest policies, which is the approach favored by traditional credit card companies. The second is to offer line-item-level interest policies, which is an approach that is gaining ground with lenders who want to offer more personalized, transparent, and safer credit and lending products.
To understand why line-item-level policies are so critical to safer credit products, it can be helpful to understand what a credit product is. Like a computer program, a credit product is information organized to accomplish a particular goal. Just as a computer program consists of routines and subroutines, so too are credit products comprised of policies that can be applied on the organizational level, the account level, and on each line item or purchase.
Policies define interest rates and fees, as well as rules around grace periods, promotions, and cash advances.
An example of a policy on an organizational level is a bank that declares it will not charge an interest rate higher than 30%.
An example of a policy at an account level is the $695 annual fee charged by the American Express Platinum Card or the Citi Double Cash Card with a $0 annual fee.
An example of a line-item-level policy would be your bank stating in your credit card contract that no interest will be charged on a particular purchase like a new dishwasher from Home Depot for ninety days after you made the purchase.
A card with line-item-level policies could also offer different interest rates for different purchases. So if you paid for a $31 dinner at your favorite burrito spot, you might pay 15% interest on that charge, but if you splurge on a new refrigerator from Lowes for $3,495, your interest rate may drop to 5% to help you afford larger ticket items.
The problem with some account-level policies is that they can be really confusing in practice. By law, credit card companies must have procedures to ensure that your bill is mailed or delivered to you 21 days before it is due. With most (but not all) credit card companies, these periods are called grace periods. Per most credit card contracts, cardholders won’t get charged interest on their purchases provided they pay the full amount they owe by the due date on their bill. If these customers pay their full balance every month without fail, they will always be in a grace period, and they will not accrue interest.
Many cardholders are not so lucky. They may make a full payment for two months and then a minimum payment. Depending on the policy of the cards that they hold, they can start accruing interest on the first purchase they make the day after they pay their minimum payment or they can also have what is called deferred interest. We’ll come back to deferred interest in a future post.
Depending on the interest accrual period of their card, if they make a purchase on day one after making their minimum payment, they will accrue interest on that purchase on day one, interest on that interest on day two, and interest on the previous two days worth of interest on day three, etc., etc. That is called compounding interest on interest, and it can lead to an expectedly large interest charge on the next bill.
Let’s look at a consumer, we’ll call her Sally, who finds herself in precisely the situation I have just described. In January and February, Sally pays her bill in full. But she splurges in February and takes her boyfriend out for a Valentine’s Day dinner. In March, her credit card bill, which covers the charge for the February dinner, is $217.05. She makes the minimum payment of $25. Sally is careful about her spending, and she only spends $75 on groceries in March. However, when April comes, she decides to make the minimum payment again because she knows she has to come up with $795 for her annual car insurance premium later that month. When the bill from her insurance company comes a few days later, Sally uses her card to pay it right away, not realizing that she will be charged interest on the payment every day until the end of the month.
If Sally had a modern credit card that offered a straight-forward line-item-level interest policy, she wouldn’t have had to worry about when she made her insurance payment. Assuming the card came with a simple and transparent interest policy, every time Sally swiped her card, she would get the equivalent of a 30-day interest-free loan on that item. If she couldn’t pay off the item by the due date, she would continue paying interest until the item was paid off, with all her payments being allocated according to a payment pouring algorithm that prioritizes her best interest (pardon the pun :)), which was also very clearly explained.
I firmly believe the future belongs to line-item-level interest policies. Credit card users expect more transparency. They expect to understand how their cards work. The old way of credit card companies making money by surprising their customers with interest and fees just won’t cut it anymore. Consumers will stop using cards they can’t trust. They’ll switch to cards with interest policies that are easier to understand. Pretty soon, they’ll open a bank account with the new provider. They’ll turn to them for additional banking services. Eventually, they’ll close their accounts with the banks that betrayed their trust.
When companies approach Canopy about launching a new credit or lending product, I always try to steer them to line-item-level policies. Line-item-level policies not only differentiate new cards in a crowded and competitive market, but they are also better for the cardholder and the card program providers who are our clients.
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Photo courtesy of Flickr and Sean MacEntee
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