Credit card debt has been declining nearly two years running. The trend drags on economic growth, but helps credit card companies stabilize earnings and losses. Image: Thinkstock

American consumers are steadily paying off their credit card debt. The Federal Reserve reported that U.S. families cut back on credit card use for the 23rd month in a row. Overall consumer borrowing, which includes credit cards and auto loans but not home mortgages, fell at an annual rate of $3.6 billion in July — the 17th decline in the last 18 months. Paying off credit card debt is helping stabilize a lending industry suffering from an epidemic of credit card delinquency. But a prolonged slide in consumer borrowing is a drag on the U.S. economy as it struggles to recover from the Great Recession.

Credit card debt drops with consumer spending

Consumer borrowing on credit cards fell 6.3 percent in July, following a 7.5 percent drop in June. The Associated Press reports that credit card debt has declined for 23 consecutive months — a record run. As American households struggle to repair their finances, economists expect they will keep cutting back on credit card use as long as incomes and employment don’t improve and banks struggling with high loan losses maintain tight lending standards. By borrowing less and saving more, families are helping themselves but hurting the overall U.S. economy, which depends on consumer spending to expand.

Consumers held in check by banks

To minimize their losses during the economic downturn, banks have made credit cards hard to get. However, The Street reports that consumer demand for credit cards remains strong. According to a quarterly FICO survey, new credit card accounts dropped by 17.7 percent during the 12 months that ended last April compared with the previous 12 months. In the same period, credit card applications fell only 3 percent. The Street said the numbers show consumers weren’t allowed access to all the credit they sought. During that time, the total amount of credit available on all U.S. consumer credit cards fell by 12.2 percent.

Credit card companies hire more lobbyists

The decline of consumer borrowing on credit cards is actually helping credit card companies. Debtmerica Relief reports that despite new credit card rules that limit interest rate hikes and penalty fees, credit card companies are becoming more stable as consumers reign in their spending. Credit card companies such as Capital One Financial and Discover Financial Services have seen earnings and losses stabilize. As consumers pay off more credit card debt, lenders are charging off fewer delinquent accounts. This allows them to spend money that was held in reserve to counterbalance losses. They are spending 25 percent more on increased lobbying efforts to influence future changes in federal laws.

The credit card industry

In a panic, credit card companies began using tactics that were highly questionable. They started raising interest rates without cause. They began slashing limits of even their good customers. They began charging fees for just about everything they possibly could. In the end, it left a credit industry that was not well looked upon by the American public.

The Obama administration stepped in recently to push for credit card reform laws. The aim was to create a watchdog-like service that kept lenders on the up-and-up. Gone are the days of lenders being largely “unregulated” and free to do as they please, depending on the market.

The new credit card reform

Although the laws governing credit cards have been signed into effect, there are still some concerns. Many analysts are optimistic about the changes, but they are cautious to have full confidence in the system just yet.

Here are some issues that have yet to be sorted out:

• Higher interest rates from the beginning. Putting a limit on interest rate increases is causing credit card companies to raise those rates right from the start. Because they can no longer raise rates without a 90-day notice, they will compensate in other areas. Consumers will also see a rise in APRs on their existing credit cards, particularly if they have any trouble in their past payment histories. Consumers need to remember that credit card companies still have the ability to raise interest rates, although there now is a universal grace period.
• Annual fee structures will change. One of the perks of opening a credit card was the ability to avoid annual fees or interest changes for customers who consistently made on-time payments. This is likely to change. Currently, only about 20 percent of U.S. credit cards have annual fees, however that amount is expected to sharply increase in coming months. The estimated annual fee will be anywhere from $50 to $100.
• Banks are looking to take advantage of grace periods by closing the window of time consumers can take advantage of them. Many banks are looking to compensate for lost revenue by charging interest from the day of purchase, instead of giving people the normal 21-28 day grace period to pay the balance in full without additional charges.
• The new Obama administration laws still do not regulate fees on balance transfers, cash advances or late payments. Currently there is a penalty rate for late payments that is averaging 28 percent. That average is expected to rise to the mid-30s by the end of the year, as credit card companies are scrambling to make money where they can.

The reformed laws

Laws that govern credit cards were sorely in need of change, and the Obama administration put these changes into effect at the right time. Unfortunately, there is still a long way to go for companies to continue lending and make a profit, while not taking advantage of borrowers.

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Installment loans are still popular, but surveys are showing that Americans are getting better at managing their credit. TransUnion made a prediction recently that credit card delinquencies should continue to fall throughout 2010, but at a much slower rate. Their studies showed that people want to pay off credit and realize how important a good credit rating is, but the unemployment rate is going to hamper their efforts. Still, TransUnion is estimating that the delinquencies on MasterCards and Visas should both drop to 1.04% by the end of the year.

How the numbers are calculated

TransUnion uses a calculation to predict how people will handle their future credit and it involves former payment habits of customers. The common belief is that the past three months’ payment habits are indicative of how a borrower will deal with credit in the future. For example, the chances of a consumer catching up on payments after just missed deadline is 86%, however if they miss two payment deadlines, that percentage drops to 62%. After three missed payment dates, the percentage is under 20%.

Numbers like this give analysts the ability to project what the future of lending will hold. Though TransUnion is making predictions that numbers of non-delinquent payments are on the rise, that rise is said to be just a fraction of how sharply it declined in past months. Full recovery is still a long way off.

Where the lending industry is headed

Director of consulting and strategy at TransUnion, Ezra Becker said that “delinquencies lag behind other statistics, like the jobless rate. Until more people are back at work, there will not be any dramatic improvements in payments being made on time.” The number of new unemployment claims has been lower in recent months than the year-long norm and that’s good news for economists. They are studying the economy looking for nascent signs of relief. They are also trying to forecast the future by combining research on mortgage, car and installment loans. Combining all forms of lending is enabling them to formulate what to expect in coming months.

One of the most closely watched states is Arizona. In the recession, Arizona was one of the hardest-hit and its turnaround is much anticipated. It is the only state where industry analysts are predicting credit card delinquencies will still rise throughout the beginning of 2010. Becker added, “Credit card reforms that take effect in February will have a material impact on the credit card industry next year.” He believes that lenders will be tight-fisted still, but will come up with new lending options for those without premiere credit histories. “The industry will adapt to new rules and a customer base with new credit requirements. Lenders will be forced to be more innovative in the products that they offer and how they manage their customers,” he added.

Consumers need to be smart

Though there are fresh products coming to the market, it’s important for consumers to be as vigilant as ever regarding their credit. New reforms are slated to aid people with all types of credit, but that does not mean that the lending process will be any simpler. For anyone needing credit, mortgage loans, car loans, or installment loans, it will be very important to have relatively good credit. Becker added, “People with very low credit scores may have to wait longer for the door of credit to open for them, but they still need to be fixing their credit now.”