What You Need to Know About Credit Cards and Risk-Based Pricing

There are many reasons why it is important to keep a sharp eye on personal finances these days, and the sometimes shocking results of risk-based pricing by credit card companies is certainly among those reasons. The practice of risk-based pricing, a setting and changing of interest rates that uses formulas based on a broad range of factors beyond how reliably bills are paid, has been garnering a lot of attention lately, with consumers testifying before congress about their experiences.

On December 4, 2007, the Senate Permanent Committee on Investigations heard testimony from Bonnie Rushing, a Florida paralegal, during a hearing on unfair credit card interest rate increases. She experienced a shocking increase in her interest rate - from 7.9 percent to 22.9 percent - despite the fact that she'd never missed or been late with a payment. This increase not only affected new purchases, but the balance that she was carrying, purchases she made and budgeted for at 7.9 percent.

Although Rushing had no explanation for what had occurred, Senator Carl Levin, chairman of the Investigations Subcommittee of the Senate Homeland Security and Government Affairs Committee, was able to explain what happened, according to a December 5, 2007, article published on ConsumerAffairs.com. Levin explained that Rushing had opened new credit accounts, store accounts, and that lowered her credit score, even though she was making her payments on time.

"She didn't realize then that simply opening those accounts and receiving those cards could negatively impact her FICO score and hike her interest rate," said Levin, according to the article.

The reason that this can happen is that the more credit accounts that are open, the higher the amount of debt that can be potentially taken on. In Rushing's case, she had suffered a fairly recent down-sizing, which resulted in a new job that, unfortunately came with a lower rate of pay. That worked to skew her income-to-debt ratio. Even her fine performance on paying her debts on time, despite financial difficulties, did not protect her from being penalized with higher interest rates by such risk pricing formulas, something that many find to be unfair.

In a December 4, 2007, story, writing for the Associated Press, Laurie Kellman described the credit card situation that led a Michigan woman, Janet Hard, to testify before congress. Despite paying more than the minimum each month, her credit card company ran "a spontaneous credit report that showed her other credit card balances and available credit on inactive accounts put the family at a higher risk of defaulting on their payments" and raised her interest rates. As Hard investigated her situation further, she found that "$3,478.39 out of $5,618 in payments" that she'd sent to her credit card company had been applied to "interest accrued over the previous two years." Thus, for each month, "about $176 out of her $200 payments went to finance charges," and during the past year "Hard had paid $2,400 but reduced her debt by only about $350." Hard told congress that she and her husband felt "robbed."

"Right now, credit card companies are the only lenders allowed to retroactively change the interest rate on a consumer loan where the consumer has met their borrowing obligations," Levin said, as quoted in the ConsumerAffairs.com story. "This unfair credit card practice needs to stop." Levin is currently working on sponsoring legislation to address such matters.

These two women are just a couple out of a huge number of consumers experiencing similar situations, having interest rates skyrocket, despite making payments on time and paying more than the minimum. Often, the consumers didn't know why their rates had gone up, with many not even realizing that they had, as they didn't receive formal notification.

Learning from the experiences of these consumers, then, means that the monthly statements should be looked over carefully, making sure that the interest rates are what they should be. To protect the credit score, it may be helpful to open only credit accounts that will be used, and try to limit the number of accounts as much as possible. Close those that are no longer being used and pay attention to debt-to-income ratios. Of course, paying off credit card debt and not taking on any more is the best way to avoid having to deal with such practices on the part of credit card companies.

Choosing the right credit card company can have a significant impact on your financial well-being. Before accepting and using a credit card, it is essential to make sure to understand all terms and conditions, otherwise you can find yourself in serious debt that can have a negative impact on your credit scores and records for years to come.