Being poor is expensive. This problematic paradox is evident with basic financial services. And judging by Bank of America’s recent decision to impose fees of almost $150 a year on what were free checking accounts, the problem is getting worse. Too bad (almost) no one is paying attention.
In January, The Atlantic’s Gillian White noted that, “free checking is basically a thing of the past.” White’s headline captures a reality for many Americans who regularly live near the bottom of their bank account. But it also misses the other side of the coin: financial services are cheaper the richer you are. This hidden driver of income inequality is embedded in something that we use every day and never think twice about: the payment system.
It isn’t what or where you buy, but rather how you pay that determines whether you ultimately benefit or lose from our economy's payment system. Antiquated and unnecessarily slow, this system indirectly imposes large costs on middle and working class families, in the process actually redistributing money up the income scale. Indeed, substantial portions of the $14 billion that people pay in overdraft fees a year, and the $9 billion in payday loans fees, are partially the result of a U.S. payment system that is slower than similar ones used in Mexico or Poland. Meanwhile, credit cards that lower-income consumers are ineligible to receive reward wealthy users for money spent. The richer you are, the better your rewards.
And while our system operates at a scale larger than major U.S. government programs, it has largely gone unnoticed by policy makers and income inequality scholars. As a result, the less money you have, the more money you spend to just be able to use the money you have.
It isn’t what or where you buy, but rather how you pay that determines whether you benefit or lose from our economy's payment system.
Did you realize that working and middle class Americans subsidize the wealthy when they pay in cash or use debit cards? Everyone appears to pay the same price, regardless of how you pay. But that’s not the case. How you pay changes what stores receive, and ultimately how much is in your wallet.
If you pay in cash, you are paying full freight. If you use a debit card, the merchant pays a relatively small processing fee. You likely get zero or very little back in rewards. On the other hand, if you use an American Express credit card, the merchant will lose quite a bit: 3 percent goes to AmEx, plus a fixed fee. So where does that slice go? Some goes to American Express, but a fair amount goes right back to the credit card user in the form of cash back, reward points, or frequent flier miles.
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It might not seem like a lot, but these perks can add up. Consider that a family charging $80,000 a year on a credit card and earning a fairly typical 1.5 percent cash back bonus will get $1,200 at the end of the year. (Full disclosure: I wrote this essay while flying on an airplane I paid for using points earned on my credit card). Those checks and points are not usually taxed, so it is equivalent to closer to $2,000 in pre-tax earnings.
That’s quite a gift from a payment system that provides lower income Americans with nothing. It is more than most families will see from the Trump tax cut and more than a family of four earning $45,000 a year receives from the Earned Income Tax Credit.
As long as merchants do not vary the price based on payment, economics dictate that people who pay using cash or debit cards are subsidizing people who use credit cards. The fancier the credit card, the larger the subsidy. Payment methods are correlated with income: lower income people are more likely to use cash, pre-paid or debit, while higher income use credit cards.
This happens for a variety of reasons. For example, not everyone can qualify for a credit card and the poorer you are, the worse the terms of the card; subprime credit cards can charge an annual feel greater than 10 percent of your credit limit. At the same time, the high costs of overdraft fees make debit cards far more expensive for those who occasionally hit zero in their bank account.
On the other end of the spectrum, platinum status and big rewards cards are reserved for the elites. One study by economists from the Federal Reserve Bank of Boston estimated that every household that uses a credit card receives $1,133 from cash users every year. This amounts to a hidden subsidy for those able to secure credit.
Another cost for lower and middle class American families is related to payment speed. America has one of the slowest payment systems in the world. Americans have to wait up to seven days for money deposited in their account to be available. This contrasts sharply with other countries that have had real-time payments for decades: South African introduced real-time payment in 2006, Brazil in 2002, Turkey in 1992 and Japan in 1973. The technology is there, but the U.S. remains inextricably stuck in the slow lane, with the Federal Reserve now setting 2020 as a goal.
As long as merchants do not vary the price based on payment, people who pay using cash or debit cards are subsidizing people who use credit cards.
A few days of delay probably does not matter if you regularly have thousands of dollars in your bank account; the minimum balance to have free checking in the new Bank of America account is $1,500. But if you are one of the more than 6 in 10 Americans who could not access $500 in case of an emergency, any delay can be costly. A cup of coffee can cost you $35 in overdraft fees if a paycheck deposited yesterday doesn’t clear in time. Even worse are the high-cost payday loans that can become a desperate person’s only option to pay rent if their ex-spouse’s alimony or child support payment didn’t arrive in time. Recent research from the U.S. Financial Diaries project shows working families cobble together income from an increasingly diverse set of sources that are highly volatile.
Put all of this together, and you can see why Lisa Servon, author of "The Unbanking of America," concludes that: “banks’ requirement to keep monthly minimum balances, the speed with which overdraft charges are levied, and the days it takes between depositing a check and having access to the money, all are a poor fit for the growing number of Americans who cope with unpredictable cash flow.”
In worst case scenarios, government policy can actually make the cost of providing free checking even more difficult. It can cost banks between $250 and $400 to establish a new checking account and another several hundred dollars a year to maintain it. As anti-money laundering (AML) regulations have grown in complexity, costs for ‘knowing your customer’ have risen sharply; one estimate is by 50 percent in just three years. Poorly targeted regulation that drives up costs often ends up impacting those least able to afford them.
In worst case scenarios, government policy can actually make the cost of providing free checking even more difficult.
The somewhat good news is there are simple steps the government could take to combat these problems. The Federal Reserve could implement and/or mandate real-time payments. Congress and financial regulators could improve AML laws and regulations to better capture bad guys and lower the costs for banks to open and maintain low cost basic bank accounts for customers.
New financial technology (fintech) is already trying to tackle some of these challenges, including the implementation of real-time payments system for some of the largest banks (including Bank of America). Of course these innovations are driven in part by a fear of non-bank fintech capitalizing on the demand for faster payments. Banks don’t want to be taxis in an Uber story. Meanwhile, employers like WalMart are working to provide employees faster access to their pay through new FinTechs like Even.
Despite these signs of progress, the reality is that income inequality is exacerbated by our current payment system. And the system does not have to be like this. The technology and alternative structures exist. Unfortunately, absent fleeting moments like the Bank of America announcement, most people and policy makers do not think about or appreciate the magnitude of the problem — or the solutions that could address it.
Aaron Klein is a Fellow in Economic Studies at the Brookings Institution. He served as Deputy Assistant Secretary for Economic Policy at the Treasury Department from 2009-2012.