Promotional introductory pricing on credit cards is a widely used marketing tool among U.S. credit card companies. To attract customers, these companies offer zero or low annual percentage rates (APRs) for temporary periods, which could last up to a year or more.1

How does promotional pricing on credit cards benefit lenders? And how do consumers respond to these offers of temporary zero- or low-cost credit card debt? These are the questions answered by Lukasz Drozd and Michal Kowalik of, respectively, the Federal Reserve Banks of Philadelphia and Boston in their paper, “The Conundrum of Zero APR: An Analytical Framework.” They note that, despite the prevalence of promotional pricing, little work has been done to study the pricing behaviors and outcomes for lenders and consumers. For their study, the authors focus on understanding the mechanisms behind promotional pricing rather than quantitative predictions, and thus, their findings are more qualitative in nature.

Drozd and Kowalik developed an analytical framework of unsecured consumer credit to determine how interest rates on credit card debt should be set. They considered that such debt is unsecured (that is, not backed by collateral such as real estate or other tangible assets) and is subject to default risk from nonpayment. Their framework builds upon an existing model of unsecured debt, but they extend it to account for an introductory promotional rate at contract origination.

Their objective was to see if introductory promotional credit cards with zero/low APRs can fit within their modified model framework. They used data from the Federal Reserve that were collected for supervisory purposes (specifically for the Dodd–Frank Act Stress Test, or DFAST). These data represent about 70 percent of all U.S. credit card accounts. Given the breadth of their data, their analysis provides insights into promotional debt pricing on an aggregate level. They chose the years 2018 and 2019 for their analysis because this period preceded the COVID-19 pandemic, and thus, as the authors explain, it represents “normal” economic conditions.

Drozd and Kowalik find that the use of promotional APRs on credit cards was widespread in 2018 and 2019. Specifically, about one-quarter of all credit card debt had an associated introductory promotional offering, and of that one-quarter, most had a zero APR rather than a low APR. The average time to expiration of the promotional period was nine months.

Following the expiration of the promotional period, APRs rose by 16 percentage points on average. The authors note that consumers tend to underestimate the importance of these “reset rates” by mistakenly predicting they will borrow less in the future, and, as a result, consumers gravitate toward contracts that feature promotional rates and high reset rates. They add that this “irrational behavior” on the part of borrowers incentivizes lenders — who are in search of profits — to offer promotional pricing instead of fixed-rate contracts.

Overall, the authors did not find changes in borrowers’ default risks between the origination of the promotion and the expiration period. Also, borrowers’ credit scores and delinquency rates on debt created during promotional periods were about the same as the average for all holders of credit card debt. (The average credit score on promotional APR accounts was 732 in the first three months after the start of the promotion, compared to 736 in the first three months after the end of the promotion.) The authors conclude that “there is no basis for lenders to expect a systematic change of default risk between the originations and expirations of promotional accounts.”

Further, they detected a large movement of consumer debt across credit card companies resulting from the promotional offerings. Specifically, they observed that almost half of the promotional debt came from balances accumulated on other credit cards that also offered promotional introductory APRs. In other words, about half of all consumers refinanced expiring promotional debt by switching to other credit card companies (known as “card flipping”) to maintain zero/low APRs for longer periods.

The authors determine that the majority of lenders lost money during promotional periods based on their analysis of a typical promotion with a zero APR for 12 months and a 3 percent transfer balance fee. (The transfer balance fee represents a source of revenue for lenders during the promotional period.2) Given the costs associated with maintaining these accounts, the authors note, the 3 percent transaction fee “appears grossly insufficient to cover the default losses suffered by lenders on the zero APR promotional accounts.”

From their analytical work, they conclude that promotions are generally undesirable for consumers because they can lead to “overborrowing” during the promotional period. The authors then theorize that in a competitive market — where lenders compete to acquire “rational” customers — zero/low APR offers should not arise because lenders can make better offers to consumers without adversely affecting their bottom line. In particular, charging interest rates that closely reflect the default probability during the promotional period leads to more cost-effective use of credit, and rational consumers should prefer such offers over promotional offers. Seen from this perspective, the prevalence of promotions is not only puzzling but also troubling, as it may signal consumer irrationality. As Drozd and Kowalik explain, the result — that zero APR offers should not arise in a market — crucially hinges on the assumption that consumers correctly anticipate their future consumption behavior. If that is not the case — which they show can explain the existence of promotions in the data — consumers may need to be better educated about the dangers of zero/low APR borrowing.3

  1. The views expressed here are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  2. The APR is the interest rate on the principal amount borrowed plus associated fees charged by the lender.
  3. The authors report that balance transfers were free in only 15 to 20 percent of the cases.
  4. There is some empirical evidence to that effect. Haiyan Shui and Lawrence M. Ausubel conducted an experiment involving the mailing of multiple credit card offers to consumers; they found that consumers chose worse contracts than they could have chosen. See their working paper, “Time Inconsistency in the Credit Card Market,” University of Maryland, Department of Economics (2005).