Card Rate Categories

While we can be thankful that CARD Act specifics are now fully defined and issuers can proceed with confidence in designing and managing their credit card programs, we still find that certain compliance-critical elements are not fully understood by some credit unions. This does not mean they are not compliant today, but rather that sometimes issuers do not fully process the business line impacts of seemingly narrow compliance topics. As a result, some credit card issuers will have difficult choices to make to remain compliant at some future date.

The most challenging issue for many CU issuers remains understanding the new card interest rate (annual percentage rate, or “APR”) categories and how they relate to overall profitability, interest-rate risk management, potential disruptive product changes, member communications, or the future time and resources required to address any mistakes in place today.

Understanding this issue requires realizing that the CARD Act created three different credit card rate types: variable, non-variable, and fixed. Because the CARD Act also constrains an issuer’s ability to reprice existing balances—specifically disallowing increasing rates on existing balances except under narrow circumstances—each rate type creates a different path to compliance for each issuer. Let’s analyze the compliance and overall risk elements of each rate type.

Variable Rates

These are simple. Variably priced accounts have APRs tied to a specific index rate not controlled by the issuer (typically the prime rate, but others can be used). An issuer defines an account as offering a variable rate by properly describing both the base index rate and the margin (the amount by which the APR differs from the index rate) in its disclosures (in addition to the frequency at which rates reset). For example, a disclosure on a variable-rate account might say: “Account is indexed to the prime rate with a margin of 4.9 percent over prime.”)

The vast majority of card accounts today are variably priced because this allows an issuer to change rates as the index rate changes without sending change-in-terms notices. It is also reassuring because most issuers assume that at some point the prime rate will increase given where we are in the rate cycle today. Variable pricing allows issuers to mitigate interest-rate risk more or less automatically under the assumption that prime and their liability costs will tend to travel in parallel.

But some issuers refer to their rates as “variable” because their disclosures say “can change rate at any time.” Issuers need to understand that this is not sufficient to make an account variably priced. An account is variably priced only if disclosures identify the index rate and the margin. When not disclosed in this way, an account falls into one of the next two categories.

Non-Variable Rates

Non-variable rates are typically thought of as what we used to call “fixed rates.” But the CARD Act refined the terminology and, along with it, the risks of this category. Non-variable accounts do disclose that an issuer may change the rate at any time, but (i) only with sufficient notice, and (ii) only on new balances. The issuer also must hold existing balances at the prevailing rate. Plus, lower-rate balances are given lower payment priority than higher-rate balances and can take years to pay off as a result.

At some point, non-variable issuers must anticipate a need to reprice by increasing rates in a rising-rate environment; this means that the old balances with lower rates can take years to fully pay off. The implications for credit risk management and compliance needs are clear: Non-variable products create a set of fixed-rate (in pre-CARD Act language) balances that take years to pay off if rates have to be increased in the future.

This may be an acceptable embedded risk for an issuer now, but anyone making that choice does need to contemplate a future moment when card rates may have to increase. This will mean sending change-in-terms notices to all impacted cardholders with all related collateral, including making judgment calls about where rates are headed and over what time period. In a worst case, an issuer may have to reprice several times in sequence if rates keep rising (with the associated cost and member disruption of multiple CIT notices).

Fixed Rates

The third category, fixed rates, is where we see the most potential misunderstanding and difficulty. By referring to an account as “fixed” or promoting it with such language as “rate will never change,” an issuer links the APR not to any specific segment of balances in the account, but instead to the account itself. This means that the account cannot be repriced in the future.

The implication here can be troubling. If for any reason an issuer wishes to change the rates of its credit card accounts, this issuer must choose between grandfathering old accounts and leaving them open for use despite the below-market rate (i.e. not solving the issue, but instead simply limiting it to existing accounts) or, more realistically, proactively closing the accounts and communicating the reason to cardholders. Presumably the issuer would then encourage application for a new card.

To our knowledge no CU has done this yet, but it is not difficult to envision the types of calls an institution that did this might receive. Given enough time all fixed-rate programs will have to address this concern. Once alerted to this issue, most fixed-rate issuers have a bit of a panic attack, though proactive efforts to address the issue before the rate environment changes can help mitigate the inevitable difficulties.

Discouragingly, we have seen vendors or other trusted voices in this community promote the marketing advantages of fixed rates without fully understanding this issue; if someone cannot explain these concerns when promoting fixed-rate product design, please carefully evaluate if they understand all of your perspectives and obligations in overall financial institution management.

Changing Your Product Type

We fully understand that some issuers choose non-variable or even fixed-rate credit card products with full information and understanding of the future burdens they create, but we still find significant portions of the credit union community do not understand these considerations. Regardless of any single issuer’s situation, there are tactics that can help reduce and eventually eliminate these risks. Getting started soon while the rate environment is in your favor is critical.

While we have yet to find an issuer that wanted to move from variable to either non-variable or fixed rate since the CARD Act became law in 2009, we certainly have worked with many who wish to go in the other direction. Most issuers with non-variable or fixed rates become uneasy once the interest-rate risk and profitability implications become clear, and often migration to a variable-rate credit card program is initiated.

As with any change of terms that requires member communication and (re-)disclosure, the issuer needs to carefully work through several elements. First, there must be careful analytic and financial analysis performed to determine the new variable price points and impact on program performance, after which the operational work to prepare the card processing software and any related support systems (e.g., front-end loan systems) can be completed.

Once this is complete and tested, the issuer must prepare new collateral and compliance documentation and initiate cardholder communication. This last part can be the trickiest and requires not only communication to the cardholders, but careful explanation and training for member-facing staff. Without careful preparation, one or two poorly handled member concerns can be perceived as a serious issue throughout the organization.

It may be useful to note that CUs considering a switch to variably priced accounts often find this a good time to include any other program design modifications. This can include such positive elements as product type upgrades, introduction/improvement of the reward program, and credit line increases; when delivered along with conversion to a variable program, such positive elements can create an overall positive outcome amidst the pricing change.

From Non-Variable to Variable

In general we find that non-variable programs can be converted to variable programs with proper disclosure and notice (whereas those advertised as “fixed” or “rate will never change” language are likely not allowed to be changed, see below). Doing so creates some ongoing obligations for the issuer, however.

The CARD Act requires all issuers to track which accounts had a post-origination rate increase and, under various scenarios, return rates to lower or original levels once the condition driving the rate increase abates. The potential scenarios and remedies are too complex for this limited space.

If a non-variable-to-variable conversion is desired, however, the issuer must understand that if card rates increase—even if at some future point when driven by a change in the index rate—the issuer must track and consider returning rates at an individual account level to the prior effective rate (even though still tied to the index). While there are some global approaches to portfolio management that make this process less onerous than it sounds, it is nonetheless an obligation we expect regulators to take seriously and monitor in a rising-rate environment.

An alternative approach for conversion is to “grandfather” existing accounts and limit variable pricing to new accounts. While a perfectly viable solution, this of course means that the portfolio will continue to embed the risk of non-variable accounts for the indefinite future (until the last account closes and fully pays off its balance).

Some credit unions do this because they wish to avoid some combination of resource commitment, work effort, compliance risk or member disruption that any conversion requires. Ultimately, however, we find few decide to take this approach as it can take more than a decade for significant migration to variable balances to occur, resulting in added servicing complexity and costs for managing a portfolio with mixed interest rate types.

From Fixed to Variable

As described earlier in this article, issuers that promoted, advertised, or disclosed that their credit card program has a fixed rate have very limited options. In our experience, these issuers cannot change the rates on existing credit card accounts and will someday confront a stark choice: Close the accounts and reap the resulting cardholder reaction, or leave them open under their current terms and live with the risks.

Once this is understood at a senior level, issuers tend to find either option distasteful. But some issuers may want to grapple with the program while times are relatively good and before the interest rate environment compels immediate action. If this is the case at your credit union, we recommend developing a careful plan to initiate a program migration to variable rates.

The first step is often to begin offering a new variable rate product set and to stop issuing fixed-rate cards. This will begin to ensure that the volume of fixed-rate accounts will go down over time, reducing the problems that would occur with fixed-rate accounts once interest rates rise. Natural migration to variable products can be helped along.

The CARD Act allows an issuer to move any balances to a variable rate if the cardholder opts into a new variable rate product; when a cardholder opts in, the issuer can move associated balances to the variable program and largely avoid any ongoing CARD Act-mandated rate tracking.

Issuers can often find proactive reasons for cardholders to move to the variable product. These can vary a lot depending on circumstance, but examples include special interest rate promotions to make the change, introduction of a reward program available only on the new product (or, on a more negative note, removal of a reward program from a fixed-rate program to incent movement), or product upgrades for migration.

But a fixed-rate issuer needs to understand that unless it is willing to actively close these accounts, its past choice to retained the fixed-rate product will result in a least some accounts surviving a long, long time—possibly until the last fixed-rate accountholder passes away.

We have encountered a few issuers that, once fully aware of the risks associated with non-variable and fixed-rate credit card pricing, choose to retain these products for competitive and strategic reasons. However, in our experience, nearly all issuers choose to move toward variable pricing once they grasp the future implications of not doing so.

While this article offers guidance on ways to mitigate the non-variable and fixed-rate cards problem, we caution that each issuer needs to evaluate the specifics of its card program before taking action. Differences in program history, membership dynamics and overall credit union position can guide the important details and pace required to effect such a member-impacting conversion.

Importantly, one fact remains true in all such projects: Line personnel or card product managers are not often empowered or equipped to consider overall management issues like interest-rate risk and product line profitability. Therefore proper attention and resourcing of this topic happens only when senior management is informed and focused in support of the staff functions. I hope you’ll open a conversation at your credit union about it.

Owner of TRK Advisors, Timothy Kolk brings more than two decades of credit card experience and expertise to his clients. Kolk has helped CUs across the United States improve their programs, better serve their members, and create long-lasting, high-performing programs. He can be reached at tkolk@trkadvisors.com or 603.924.4438.