Credit Cards Aren’t as Competitive as They Want You to Believe
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It's hardly news to say that credit cards are a big business. You can't browse the web, listen to the radio, watch a television show, or even open your mailbox without seeing some sort of advertisement for a credit card. And with the number of big name celebrities willing to shill for credit cards (and poke fun at themselves at the same time), it's pretty clear that all of this advertising is doing its job — generating more customers who owe money. (See also: How Credit Card Companies Prey on Your Basic Needs)
But considering the fact that as of January 2010, there were 609.8 million credit cards held by U.S. consumers (and the population of the U.S. is only 315 million, by the way), it leads us all to wonder — who exactly are these credit card companies advertising to?
The obvious answer would be pre-existing cardholders. The credit card industry seems like an obvious one for competitive marketing. Not happy with your current APR? Switch to us!!
But according to several economists who have studied the credit card industry, this market seems to present a paradoxical lack of competition. As David M. Frank of Iona College wrote in his paper To Switch Or Not To Switch: An Examination of Consumer Behavior in the Credit Card Industry, "One could expect that competition would be abundant because many firms compete in this market. Ironically, even though competition is intense, the industry fails to offer consumers the traditional benefits arising from competition."
Theoretically, if there is a large market available for consumers to choose from, they can easily go from one vendor to another if they are unhappy with service, prices, or other aspects of their experience. But the credit card industry, despite the apparently fierce competition, is not offering consumers the kinds of choices we might want to find in an abundant marketplace. Here are the reasons why credit cards have to chase us so aggressively, and why we're unlikely to switch cards, even if we're unhappy.
Consumer Behavior Limits Card Switching
One of the very interesting findings from Frank's research was the fact that "98% of the people surveyed [regarding credit card usage and preferences] held credit cards, while only 52% knew their interest rates."
This is a significant finding, because comparing APRs is one of the few ways of determining how good a credit card deal you have. So why are up to 48% of people completely unaware of how much they are paying in interest?
One potential reason for this has to do with how people regard their credit cards. Some credit card users are very disciplined about the use of their cards and pay off their balance each month. These individuals might not know their interest rate because it is irrelevant — they never have to pay it.
The cardholder who is more likely to know their APR off the top of their head is one who is carrying a balance and who is concerned about paying it off. And according to Frank's study, those individuals who have reached their credit limit are both more likely to know their APR and are more likely to be interested in switching to a different card.
Unfortunately, the no-balance cardholder who doesn't know their APR is the person much more likely to have excellent credit — and is therefore very attractive to another credit card company. The individual who has maxed their card and would desperately love to switch to a card with a better APR is likely to be more of a credit risk — and is therefore less likely to field balance transfer offers.
That helps explain in a nutshell why competition in the credit card industry is unlike competition in other arenas. Since cardholders are in a long-term relationship with their issuer, their behavior can limit interest on both sides when it comes to switching.
Another aspect of switching credit cards that makes it very different from switching laundromats or grocery stores is the fact that your credit can take a hit. 15% of your credit score represents the length of your credit history, so canceling an old card can shorten your credit history — and hurt your score.
According to Connie Prater of CreditCards.com, "determining the monetary cost of a decreased credit score can be complicated. It can mean the difference between getting or not getting a personal loan or getting a car loan at a higher interest rate. This can translate into hundreds or thousands of dollars over the life of the loan."
Basically, that means that savvy consumers — the ones who have good credit scores and are attractive candidates for credit — are again less likely to switch to a new credit card. The ones who are willing to take the credit score hit are often those individuals that couldn't get a good rate through switching in the first place.
Imagine you have held the same credit card for over five years. It's been a pretty good card, but you've recently discovered you could get a better interest rate plus some nice cash back bonuses if you switch to a different card. Will you go for it?
Before you decide, start thinking about how many of your automatic payments are made through your current credit card. In addition to having it as your go-to card for Amazon and other Internet shopping, that card is how you pay your monthly gym membership, your cell phone bill, your magazine subscriptions, your utility bills, etc.
Are you still as gung ho about switching to the new card?
This phenomenon is what economists refer to as switching costs. Whenever you change from one service provider to another, whether it's your cell phone company, your credit card, or your grocery store, there will be certain costs to your switch. In some cases, they will be actual financial costs, but in many instances in our modern world, they are time costs.
How much of a pain in the rear will it be to alert all of your service providers to your new credit card information? It might just be enough to make you decide to stay put with the worse APR.
In addition, there are some financial switching costs that are built in to the credit card industry. For instance, one major enticement for switching to a new credit card is to take advantage of a teaser balance transfer rate. However, the ads promoting those teaser rates rarely mention the balance transfer fee — which is generally some percentage of the amount transferred — and the standard rate which will go into effect at the end of the teaser period or if you miss a payment.
And of course, credit card companies do not want you to go. As Connie Prater writes, "since it costs more to sign up a new customer than to keep an old one, credit card issuers often try to woo you back into their good graces with offers of a lower APR, no annual fees or other inducements." As anyone who has ever tried to cancel a credit card, cable, or other long-term relationship service can attest, it's more like breaking up with a needy boyfriend or girlfriend than a simple business transaction. ("I can change! I promise!")
Locking You In
Not only will your credit card company snivel and beg to keep you if you threaten to walk, but it also makes sure to lock you in with loyalty. The types of rewards that many cardholders enjoy — from free airline miles to cash back bonuses, all work to keep you using the same card year in and year out. Since you cannot transfer your rewards and bonuses from one card to another, you are essentially locked in with your current credit card.
According to economists Kevin Amess, Leigh Drake, and Helen J. Knight, who conducted a study in England on the effects of loyalty programs on credit card behavior, "our evidence also indicates that the Airmiles loyalty scheme is an attribute that issuers use to create customer lock-in. This is an attribute associated with switching costs." Basically, the study found that the loss of airline miles (or other loyalty bonuses) can be considered a switching cost that cardholders are unwilling to pay.
It gets worse. The study also found that credit card companies offering loyalty bonuses also had much higher APRs — on average 16.56% higher. The study's authors write: "This is consistent with issuers using [loyalty schemes] to create customer lock-in with switching costs and exploiting lock-in with higher prices."
Credit card issuers realize you're a captive audience, and take advantage of it by upping the APR.
Making Sense of the Credit Card Marketplace
Despite the fact that credit card companies are spending billions of dollars each year to entice all of us to open a new card or switch to them, there is a great deal less real choice available than the constant ad bombardment would lead us all to believe. Rather than a free market, we have a credit card market that is limited by both our own behaviors and preferences and by the lock-in schemes of the credit card companies.
That's not to say that someone with excellent credit and a hankering to move on to greener credit pastures won't be able to find a new card. But for most of us, momentum and apathy are likely to keep us with the same card for several years.
The trick is to make sure you do your homework when you originally sign up for a card. That means you'll generally still be in a good place years later.
And if you're not — you can always threaten to break up with your card. That usually brings out the promises to change.