Road to hell is paved with good intentions. Various lawmakers in USA are proposing that the credit card interest rates must be capped. While their intentions might be noble, the consequences are likely going to have bad impact across the US economy.

Understanding business model around credit cards

Credit card lends money to the user in near real time. When you use a credit card you are essentially spending the bank’s money instead of your own. As long as you pay your credit card bills on time, you are fine. However when you spend more than you earn and can’t pay the bills you have to pay an interest to the bank.

Contrary to what everything might think, banks do not want you default on your payment. Instead banks want you to pay your bills on time. Banks earn their profits from the 1-2% transaction fees they charge the merchant.

As we all know, lending money is a very tricky business. Some people are trustworthy and some are not. The banks encourage trustworthiness by offering 0 interest to those who pay their bills. For those who default the interest rate is determined by the market forces and competition.

What happens if interest rates are capped ?

If the interest rates are capped banks will suddenly find it way too risky to lend money to less creditworthy individuals. This basically would lead to scenario where poor people might not qualify credit cards at all. Hence such people will be forced to spend money they have in the bank. As we all know, this makes life hard for them. What is worse is that these people might have to resort to payday loans and other methods which charge even greater interest for their day to day spending.

Eventually this impacts the consumption as well. If people don’t have credit cards they will spend less and as a result this would impact what local businesses earn. Less income for them also means less jobs for that area. Since American neighborhoods often are gentrified it would mean less jobs in poor neighborhood further making life of poor people even more difficult.

Helping people with credit card debt

Good economics also helps poor people. The correct way to help credit card debt owners is to allow banks to provide more innovative products. Increasing competition among banks and reducing regulations for low credit limit cards might go a long way in helping banks offer better products to poor customers.

Congress has often failed to pass sensible regulations here and instead have passed dubious regulations that have harmed the banking sector and consumers alike.

Large companies like Walmart were denied banking licenses for frivolous reasons. Had the Congress and other regulators had focused on passing sensible regulations that reduce red tape and increase banking competition we would have been in a much better shape than what we are currently in terms of credit card debt.