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On June 14, 2007, the Board of Governors of the Federal Reserve System (the Board) published a notice of proposed rulemaking for its long-awaited amendments to the open-end credit sections of Regulation Z, the Board's implementing regulation for the Truth in Lending Act (TILA).1 TILA is the federal law requiring creditors to disclose the terms and conditions of consumer credit plans and transactions, such as credit cards, car loans, and mortgages. TILA applies at all stages of consumer credit, including advertising, application, account opening, and consummation.
The proposed amendments are the first phase of the Board's comprehensive review of Regulation Z. The Board's goal is to improve the effectiveness of the disclosures creditors must provide to consumers. Because of the regulation's complexity, the review was scheduled in two phases. The Board first examined the regulation's open-end credit sections (except credit secured by a consumer's home) and is now reviewing the closed-end sections. The Board last conducted a comprehensive review in 1981.
The proposed amendments focus on five areas of open-end credit: (1) application and solicitation disclosures; (2) account-opening disclosures; (3) periodic statement disclosures; (4) change-in-terms notices; and (5) advertising provisions. To enhance the effectiveness of the disclosures, the Board retained a third-party consumer testing firm, Macro International, Inc., to conduct extensive consumer testing of existing open-end credit disclosures as well as the Board's proposed changes. The results of the testing influenced the changes to the disclosures, and the Board has indicated that all future amendments will undergo testing. For interested readers, Macro prepared a detailed memo discussing the testing.2 This article highlights the proposed amendments.
Credit and Charge Card Application and Solicitation Disclosures
The proposed amendments contain significant changes for credit card solicitations and applications. Regulation Z requires card issuers to disclose key costs and terms in a prominent table known as the Schumer Box (named after New York Senator Charles Schumer, who introduced the bill in Congress with that requirement). The proposed amendments would modify the requirements for the Schumer Box disclosures with respect to disclosures for penalty pricing, penalty fees, balance computation method, variable-rate information, payment allocation, subprime credit cards, and new required reference to the board's consumer credit education website. The changes are discussed below.
Penalty pricing. Under the current version of Regulation Z, card issuers must disclose all interest rates that can be used to compute finance charges in the Schumer Box. Most credit cards specify different annual percentage rates (APRs) for different card transactions, such as a purchase APR, a cash advance APR, and a high-rate penalty APR that is triggered when a cardholder defaults on the cardholder agreement. The current regulation does not specify how to identify a penalty APR. Most issuers use the term "default APR." The current regulation also requires that the circumstance triggering a penalty APR be disclosed outside the Schumer Box.
The proposed amendment requires card issuers to use the specific term "penalty APR" to identify a penalty APR and to identify the circumstance triggering it inside the Schumer Box. Consumer testing inspired these changes because it revealed that many consumers did not understand the concept of a penalty APR when it was identified as a "default APR," but they were able to comprehend it when the term penalty APR was used. Testing also revealed that many consumers do not read information outside the Schumer Box.
Penalty fees. Section 5a of the current version of Regulation Z requires credit card issuers to disclose cash advance fees, late payment fees, over-the-limit fees, and balance transfer fees in solicitations and advertisements either in the Schumer Box or clearly and conspicuously elsewhere in the application or solicitation. The amendments would require that these fees appear inside the Schumer Box because testing again revealed that consumers did not notice fees disclosed outside the box. The amendment also requires a new disclosure for a returned payment fee.
In addition, if the circumstances triggering a penalty fee will also trigger a penalty APR (e.g., for paying late), the penalty fee must cross-reference the penalty APR disclosure. The model form shows this example alongside the disclosure for a late payment fee: "Your APRs may also increase; see Penalty APR section." The interested reader can view the disclosures in the revised Schumer Box in a model form that the Board published in the rulemaking notice.3
Balance computation method. The balance computation method disclosure is no longer required to be disclosed inside the Schumer Box and can instead appear outside it. Testing revealed that that the different balance computation methods were not meaningful to consumers who do not consider such information when shopping for a card.
Variable-rate information. Currently, Regulation Z requires card issuers with variable APRs to disclose inside the Schumer Box the index or formula used to make adjustments to the APR and the amount of any margin that is added. Other details are disclosed outside the box, such as how often the rate can change. Under the proposed amendment, information about variable APRs would be reduced to a single phrase indicating the APR varies "with the market," along with a reference to the type of index used to compute the APR, such as the prime rate. Testing revealed that few consumers focused on variable-rate information when shopping for a card, and many were confused by details about margin values.
Payment allocation. When a consumer submits a payment on an account with multiple balances subject to different APRs, most card issuers will allocate the payment to the balance with the lowest APR first. This practice has created confusion for consumers when they accept balance transfer solicitations for credit cards that offer a zero percent APR for a specified period on the transferred balance, but not on new purchases. Many consumers do not understand that if they make new purchases and remit payment for the new purchases by the due date to avoid finance charges, but pay nothing toward the transferred balance because it has a zero percent APR, the payment may not be allocated to the purchase balance but instead be first allocated to the transferred balance because it has the lowest APR. As a result, finance charges will accrue on all new purchases until the transferred balance is paid off in full.
The proposed amendment addresses this issue. It would add a new disclosure to the Schumer Box about the effect of card issuers' payment allocation methods when payments are applied entirely to transferred balances at low introductory APRs. It would alert consumers that they will incur finance charges on any new purchases until the transferred balance is paid in full. The Board's model form for the proposed credit card amendments shows one method of making this disclosure: "Notice Regarding Interest Charges: Your introductory APR applies only to balance transfers, not to purchases. During the introductory period we will apply your payments to transferred balances before we apply them to any purchases you make. You will be charged interest on all purchases until your entire balance has been paid off completely, including transferred balances."4
Subprime credit cards. Federal banking agencies frequently receive consumer complaints about subprime credit card offers. Consumers state that when they applied for subprime credit cards they did not understand that substantial fees are required to open the account, which are billed to their first periodic statement, and that the amount of available credit is often small, especially after it is reduced by the required fees. The Board cited an example of a subprime card with a $250 credit limit and $100 in required fees that left a remaining credit limit of $150 when the account was opened.
To address this issue, the proposed amendments require that when mandatory fees are equal to or greater than 25 percent of the minimum credit limit offered on the account, the card issuer must include an example in the Schumer Box of the amount of available credit after paying fees or security deposit. The Board included a proposed model form with this example: "NOTICE: Some of these set-up and maintenance fees will be assessed before you begin using your card and will reduce the amount of credit you initially have available. For example, if you are assigned the minimum credit limit of $250, your initial available credit will be only $68 (or $53 if you choose to have an additional card)."
Another important change is the treatment of a fee to apply for a card that is imposed regardless of whether the application is approved. Under the existing regulation, the fee would not have to be disclosed in the Schumer Box because it is not imposed for the issuance or availability of credit. The proposed amendment would eliminate this exception and require disclosure of the fee in the box because the Board believes consumers should be aware of it when shopping for credit.
Reference to the Board's website. All card issuers would also have to include a reference to the Board's website in credit card applications and solicitations. The website provides information on comparing credit cards and the factors to consider. During the rulemaking, commenters suggested that the Board consider nonregulatory approaches to educate consumers about credit. The Board's current website for credit card shopping will be expanded to provide additional information on helping consumers shop for credit cards.5
Open-End Credit Initial Disclosures
Under the current version of Regulation Z, the Schumer Box is only used for credit card solicitations and applications. The proposed amendment requires the use of the Schumer Box to disclose key terms for all initial account disclosures for open-end credit products as well. Consumer testing revealed that many consumers do not read initial account disclosures because they are long, complex documents. Testing further revealed that consumers reacted favorably to a separate insert of key disclosures of account terms and conditions in a tabular format. The key terms are: interest, minimum charges, transaction fees, annual fees, and penalty fees (e.g., late payment).
Another important change is that card issuers would not have to include fees and costs other than the ones listed above in the initial account disclosures. The Board received comments indicating that some charges are not incurred until years after the account has been opened and that disclosing them initially does not benefit consumers. The creditor would only be required to disclose other charges prior to the time the consumer becomes obligated to pay them. For example, if a creditor charges a fee to retrieve an old account statement, the creditor would have to disclose the related fee when the customer called to request the statement and before the charge is imposed. While Regulation Z has always required written disclosures in a form the customer can keep, the proposal would allow creditors to disclose the charges orally. This change was permitted because consumers often contact creditors by telephone when a written disclosure is not feasible.
To help consumers understand the cost of credit, the proposed amendments would require disclosure on the periodic statement of the total fees incurred during the billing cycle separate from the total interest charges incurred during the cycle. In addition, the interest charges would have to be itemized (e.g., interest charges resulting from purchases and interest charges resulting from cash advances). The proposal would also require year-to-date totals for both interest and fees. Testing revealed that consumers understand the cost of credit better when it is expressed in dollar amounts.
The Board is also soliciting comments on whether to eliminate the effective APR disclosure on periodic statements or to take steps to improve consumers' understanding of it. The effective APR refers to the consumer's actual cost of credit during the billing cycle, including interest charges and fees that are considered finance charges under Regulation Z, such as a fee for a cash advance or balance transfer. Testing revealed that many consumers do not understand it. Creditors complain that the effective APR disclosure confuses consumers who do not understand it, while consumer advocates acknowledge that it is not widely understood but suggest it should be improved rather than eliminated.
Another change to the periodic statement concerns the minimum payment warnings required by the 2005 amendments to the Bankruptcy Code. The proposal would require three new disclosures on periodic statements: (1) a warning that making only the minimum payment will increase the interest paid and the time it takes to repay the balance, (2) a hypothetical example of how long it would take to pay a specified balance in full if only minimum payments are made, and (3) a toll-free number consumers can call to obtain an estimate of how long it would take to repay their account balance using minimum payments.
Regulation Z currently requires creditors to provide 15 days' notice for changes to any account term required to be disclosed under section 6 of Regulation Z for initial disclosures. However, if the change resulted from a customer's default or delinquency, card issuers do not have to provide 15 days' notice (though they still had to provide written notice). Certain other events required no notice at all, including late payment charges, over-the-limit charges, and changes that were disclosed in the initial account disclosures, such as an increase in the APR if the customer makes late payments. Testing revealed that consumers typically did not read change-in-terms notices because they were in small print and used dense text. As a result, consumers are often surprised to learn that important account terms have changed.
The proposed amendment addresses this problem in several ways. First, if the change-in-term notice pertained to a key term that must be disclosed in a Schumer Box for initial account disclosures (one of the new requirements discussed above), then the change-in-term notice must use a similar format. Many creditors send change-in-term-notices along with the periodic statement. Because testing revealed that consumers tend to disregard notices sent with the periodic statement, the notice included with a periodic statement must appear in a Schumer Box above the list of transactions on the statement. Testing revealed that most consumers examine the list of current transactions on the periodic statement.
The proposed amendment also requires that creditors send a change-in-terms notice 45 days prior to any change instead of the current 15 days. It would also expand the circumstances in which the notice must be sent. When a creditor increases an APR because of a default or delinquency, it would have to send a notice 45 days before the change, even if it had disclosed this possible change in the initial account disclosures. The purpose of this change is to allow consumers adequate time to shop for new credit prior to the rate increase taking effect or stop making purchases with the card to avoid increasing the balance that will be subject to a higher APR.
The proposed amendment contains two new restrictions on advertisements for open-end credit. The first concerns advertisements that offer financing for products or services and mention the consumer's minimum monthly payments if financing is selected. The proposed amendment would require creditors to disclose, in equal prominence to the minimum payment, the time period required to pay the balance if only minimum payments are made.
The second restriction applies to advertisers who use the term "fixed" rate. Under the proposed amendment, if the advertiser uses the term "fixed" rate, it must identify the period during which the rate is fixed and cannot be increased. If a time period is not identified, the advertiser cannot use the term "fixed" rate unless the rate cannot increase while the credit plan is open.
Compliance Corner readers are encouraged to comment on the Board's proposed amendments to Regulation Z by October 12, 2007. All public comments received by the Board are available on its website. All public comments appear as submitted unless changes are necessary for technical reasons. Comments are not edited to remove identifying or contact information.
If you have any questions regarding this article, please contact Consumer Regulation Specialist Kenneth J. Benton or Supervising Examiner John D. Fields through the Regulations Assistance line at (215) 574-6568.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.