FEBRUARY 2005

Rise in Credit Card Debt

The January 2005 issue of Spotlight reported on the rise in noncash payments and the prediction of 2007 as the year in which plastic payment (both credit cards and debit cards) will overtake checks as the preferred payment method at the point of sale. A recent working paper by Federal Reserve economist Kathleen W. Johnson takes a close look at the "convenience use" of credit cards as payment device, and the contribution of credit card transactions to the growth of credit card debt in the past decade.

The Federal Reserve's aggregate measure of revolving consumer credit, the vast majority of which is credit card debt, grew at an annual rate of 9.2 percent from 1993 to 2003. This rapid increase in credit card debt has led some analysts to conclude that U.S. households are financially vulnerable. One of the shortcomings of the Fed's revolving credit statistic, however, is that it does not distinguish between credit card charges that will be paid off in full ("convenience use") and credit card charges that will be carried over more than one billing cycle ("new borrowing"). Johnson's analysis separates the effects of convenience use and new borrowing on the increase in credit card debt.

Johnson outlines the impact of convenience use of credit cards in the evolution of the credit card market. The first cards were convenient payment instruments and not intended for new borrowing because balances were due in full each month. Over time, credit card use grew due to a number of factors including the speed and security of credit card transactions, the option available to borrowers to revolve balances, rewards and discounts offered by card issuers for card use, the increase in e-commerce, and wider acceptance of cards by merchants.

Aggregate measures of convenience use range from 2 to 10 percent of outstanding credit card debt, but suffer from the inability to take into account the increase in new accounts and new borrowing in the 1990s. Household-level data, however, allows for the separation of convenience use and new borrowing and suggests that convenience use may range from 5 to 7.5 percent of revolving consumer credit. Johnson uses household-level data from the Federal Reserve's Surveys of Consumer Finances to model demand for credit card charge volume, both new borrowing and convenience use over the period 1992 - 2001. The model takes into account changes in household characteristics, household attitudes toward credit, alternative definitions of credit cards to include or exclude retail store cards, interest rates of general-purpose cards, and household card credit limits. "These alternative specifications suggest that convenience use accounts for about 5 to 10 percent of measured credit card debt on average over 1992–2001."

Johnson concludes that convenience use increased an average of 14.5 percent per year over the period 1992 and 2001 versus 6.5 percent per year for new borrowing over the same period. The growth in the convenience use of credit cards contributed to the rapid rise in the level of credit card debt, particularly in the late 1990s. Absent the rise in convenience use, "...measured credit card debt growth would have been almost one percentage point per year slower between 1992 and 2001, and measured credit card debt levels would have been 7.5 percent lower." Based on the significant contribution of convenience use to the increase in measured credit card debt, Johnson cautions that "an increase in debt stemming form such convenience use likely would not signal greater financial vulnerability for households...and may distort conclusions about household indebtedness that are based on measured credit card debt."