no third solution

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Credit Card Scams Part IV: The Penalty Rate Scam

June 20th, 2008

Among the other scams perpetrated by credit card issuers, the Penalty Rate Scam is equally nefarious. All of the scams implemented by credit card issuers work in lock-step with at least one of the other scams.

  1. Debt Collection Practices & Impropriety
  2. The Reverse Payment Prioritization Scam
  3. The Balance Transfer Scam
  4. The Penalty Rate Scam
  5. Exploiting Ignorance: Money for Nothing

Under the terms of most (all?) credit card use agreements, the borrower accepts a default of Penalty Rate which goes in to effect in the event that borrower is late in remitting a single payment. The Penalty Rate is usually the maximum allowed by law, and often in excess of 24%. I have seen or heard of Penalty Rates as high as 29.99% but I suspect that in some jurisdictions they might be even higher.

It could be argued that there is justification for the Penalty Rate, as borrowers who are late or miss a payment are greater default risks. This very well may be true, but suffers from some variant of the post hoc, ergo propter hoc logical fallacy.

  1. Borrower misses a payment
  2. Borrower defaults

Did you see what happened there? They intentionally left out the interim step; the one where the borrower’s rate jumps from 9% to 25%, doubling or tripling the interest portion of the monthly payment!

This causes a negative feedback loop: If someone is diligently trying to pay down a credit card balance, paying $300 each month when the minimum payment was $150, the new, penalty minimum payment amount will be approximately $300. This effectively relegates the borrower to making interest-only payments (i.e., no amortization, whatsoever) for the duration which the Penalty Rate is in effect. This may be for a period of six months or longer. During this time, the borrower may continue to make payments in the amount which his or her budget permits, but is unable to reduce his balance in any meaningful manner.

The ability to repay or to pay down the balance is without a doubt negatively impacted by the imposition of a Penalty Rate.

I submit that the Penalty Rate, by itself might be sufficient cause for a large proportion of defaults. Before objecting, think on the margin: any borrower who was scraping by, is now unable to scrape by. These borrowers who would’ve been OK, had they tightened their belt, are now forced into default by the new, higher interest rate.  Theory dictates that the Penalty Rate is indisputably a prime contributing factor to default.

When analyzing data through extrapolated variables, there will always be an unusually strong correlation between the new variable, and the definitional components thereof. It is of paramount importance to avoid making value judgments or inferring causal relationships under such circumstances. There may well be a causal relation between a single missed payment and default, but the noise-to-signal ratio here is about a billion to one. Since the Penalty Rate has a 1:1 correlation with default (by definition, default always occurs after the imposition of the Penalty Rate) there is simply no way to know what the true default rate would be if the penalty were less onerous.

Under more proper loan provisions, there is usually a penalty for late payment, but it is almost never usurious (frequent readers of this blog will recognize that I rarely use this term, and then only carefully). Credit card companies seem to do everything they can to encourage default.

The Penalty Rate works in tandem with the Debt Collection Scam: interest and penalties pile up in order that the lender can claim a larger debt than would otherwise be due. This new debt bears no relationship whatsoever to any anticipated return on investment primarily because there was never any investment to begin with. The higher debt, now in default, is the starting point for any negotiations, arbitrations or legal action.  In essence, the creditor creates phantom debt which is treated by the courts and by corrupt arbitrators as valid. This is not about earning a fair return on borrowed money, it’s about exploiting people’s ignorance and subsidizing interest-free loans to people who don’t need them, none of which would be possible in a free market where debt couldn’t be created out of thin air.

no third solution

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