Priceless or Just Expensive? The Use of Penalty Rates in the Credit Card Industry

26 Pages Posted: 20 Aug 2009

Date Written: December 16, 2008


With roughly a trillion dollars in credit card debt, Americans have come to rely on their credit cards as both a form of payment for purchases and a flexible way to borrow cash. Credit cards are also a key source of income for financial institutions, with a rate of return that tends to be much higher than most other consumer loan products.

While credit card companies compete to offer the lowest 'headline' rates in solicitations, they also depend on less obvious tactics to boost their financial returns. Credit card issuers at one time charged a single fixed interest rate to all customers and now charge several varying interest rates at once. Some of these interest rates expire after a short time period, and some suddenly change to 'penalty rates' under certain conditions. The number and importance of fees charged to consumers has also grown, with penalty fees up 69% between 2003 and 2007 according to the credit card industry consulting firm R.K. Hammer. Repricing customers based on penalty triggers is a common revenue-boosting strategy.

This study shows that penalty repricing leads people to underestimate the interest they are paying and that credit card issuers try to keep it that way. Furthermore, it shows that penalty repricing is increasingly common and there is a growing disparity between the size of the penalty and what consumers expect to pay.

More specifically, this study finds:1) Almost 11% of all balances borrowed on credit cards carry penalty pricing, and the majority of borrowers being charged penalty rates do not realize it. This lack of knowledge is not surprising given that credit card issuers do not give borrowers explicit notification when invoking penalty pricing, and routinely reprice accounts when borrowers make payments just one day late. 2) While penalty rates have been climbing, 'penalty shock' (defined as the increase over the regular rate) has increased even more sharply, with penalty shock more than doubling between 2001 and 2007. In 2008, the average penalty annual percentage rate (APR) was 16.9 percentage points higher than the average non-teaser purchase APR. 3) For a household with the average amount of $10,678 in credit card debt, being penalty repriced on all their balances would result in an additional $1,800 in interest costs per year. 4) The prevalence of penalty rates in credit card terms has been rising, with a penalty rate in the terms of 94% of new credit card solicitations issued in 2008. This is compared to 82% in 2003.

Keywords: credit cards, penalty APR, default APR, universal default, information, risk-based pricing, moral hazard

JEL Classification: D14, D18, D43, D82, D83, G21, G28, L50, L80

Suggested Citation

Frank, Joshua Mayer, Priceless or Just Expensive? The Use of Penalty Rates in the Credit Card Industry (December 16, 2008). Available at SSRN: or

Joshua Mayer Frank (Contact Author)

Center for Responsible Lending ( email )

302 West Main St.
Durham, NC 27701
United States
9193138525 (Phone)
919-313-8592 (Fax)


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