By now, most people have become familiar with the additional hoop they have to jump through when buying things at the store. When you get to the checkout counter you do an awkward dance: do I swipe my credit card, do I put it into the chip reader, do I need my PIN, can I pay with my phone? The United States is currently in the middle of an update to its credit card infrastructure, an update that has been difficult for many consumers to navigate. What’s behind the recent changes and why have they just started now?

History and Background

The technology behind the original magnetic strip card was developed as early as the 1960s, but credit cards didn’t become a mass technology until the 1980s. Before then, their use was largely limited to business people and frequent travelers. The main issue originally holding plastic back was the cost. Namely, in the United States transaction costs were relatively low, a few cents each, because they were conducted over phone lines. In Europe, however, transactions were not done this way, leading to much higher costs. And using phone lines was actually a step up from the initial way credit cards were authorized, through carbon papers. When that was the case, people could commit credit card fraud by simply digging through dumpsters.

The video below gives a detailed account of the history of credit cards:

Because the European credit card system was so susceptible to fraud, European companies needed a more secure way to process transactions. Stakeholders got together and began to develop an alternative. This alternative, chip card technology or the formal name, EMV, was unveiled in 1994 and became widespread by 1998 in Europe (EMV stands for Europay MasterCard Visa). Despite widespread usage of EMV technology in Europe and other parts of the world, it has been slow to gain traction in the United States. It was only in 2015 that American companies and merchants began a concerted effort toward adopting EMV.

Adoption in the United States

So why did the United States ultimately decide to switch to EMV cards in 2015 when the technology had been readily available since the 1990s? The primary answer is the recent surge in credit card fraud, starting with the massive hack at Target in 2013 in which millions of credit cards were stolen. This hack, along with several other high-profile incidents, revealed the truth. Namely, companies were trying to secure customers’ data in the 21st century with cards from the 20th. The accompanying video looks at why the United States switched to EMV and what it means for cardholders:

However, the recent change was not the result of a top-down mandate from the government. In fact, the effort was led by a private group of credit companies including American Express, Discover, MasterCard, and Visa. The 2015 deadline was not a concrete point of no return, but one created by the same credit card companies. While companies did not have to meet the deadline by law, the liability for card-present fraud would shift to those who do not comply with the new technology. In other words, if a company or a bank did not adopt the EMV technology by that date and was the victim of fraud then it was on the hook for the cost.

While retailers had until 2015 to comply, automated gas dispensers have until 2017. Likewise, ATMs also have a little extra time–Mastercard and Visa ATMs must make the shift by October 2016 and 2017 respectively.

Advantages of Chip Enabled Credit Cards

Aside from following in Europe’s lead and satisfying the requirements of credit card companies, the EMV cards offer a number of advantages over traditional cards. First and foremost is security. Whereas traditional cards have one magnetic strip that can be easily copied onto a fake card, EMV cards do not. Instead, the EMV cards utilize the chip embedded in the cards, which creates a different transaction code for each purchase. As a result, if someone manages to get that transaction data, the code is unique to a specific transaction and cannot be used again for future purchases.

EMV cards work in two ways. They can be dipped into a machine, where they have to be held for a few seconds longer than it takes to swipe a traditional card. The card can also be held up to a contactless device, however, these devices are more expensive and less likely to be available as the technology is only now entering the American market.

Another distinction for these type of cards is the actual transaction process. Most of the models in the United States will be the traditional swipe or dip and then sign. Currently, most new credit cards have both a chip and a magnetic strip in case a store’s technology has not yet been updated, but in the future, cards will likely only have chips in them. There is an even more advanced version that requires consumers to enter their PIN numbers after dipping the card, but it costs more and is less likely to be seen in the United States anytime soon. In fact, this type has almost been discouraged as the major credit card companies that initiated the switch to EMV cards did not require them to be “Chip and PIN” models.

The video below from Mountain America Credit Union looks at the chip card and some of its advantages:

Disadvantages of Chip Enabled Credit Cards

Even with the deadlines, adoption of the EMV cards has been a slow process. By 2015, 25 percent of new cards issued were EMV. By the end of 2016, a year after the deadline, that number is projected to be only 75 percent. While part of this is due simply to technological limitations and the difficulty small banks can have when switching up their technology, there is more to the story that just that.

Namely, the switch will be very expensive. Updating the millions of traditional card readers will cost approximately $7 billion. On top of that is the cost to replace the cards already out there, which is estimated to be another $1.4 billion. Last, there is the cost  to replace ATMs and old software so that they can read the new cards, a change that may cost up to $500 million.

Although the chip cards’ chief advantage over traditional cards is safety, they are far from hacker-proof. Now instead of targeting the cards themselves hackers can target the machines that read them. Specifically, criminals can drill or even insert devices into card readers that are able to read the information protected on the cards. Using this information, thieves have been able to make counterfeit cards with magnetic strips and use them in places that do not have the new technology.

On top of security is also the issue of privacy, as the new cards also transmit a large quantity of data. Information, like a person’s present location, may become available if the card is hacked. Lastly, the cards are slower to process and many of the merchants required to make the shift either do not understand the technology or its benefits.

Finally, while it is not the fault of the cards themselves, experts suggest that stiffer security from the new cards will lead to greater rates of card-not-present fraud like online transactions. While these cards may improve security for in-person transactions, fraud may simply move elsewhere.

Conclusion

EMV cards have long been popular in Europe and other markets, yet Americans have been resistant. But that resistance crumbled when a series of hacks revealed how easily credit card information could be obtained. The new chip cards do offer advantages, most notably in terms of security. However, they also have a number of disadvantages and will not get rid of fraud altogether.

Not surprising then, even following deadlines for adoption required by credit cards companies, many American merchants have been slow to endorse them. Additionally, American consumers have also been slow to embrace the new technology due to its slower transaction times. Nevertheless, EMV technology is likely here to stay and will soon become the dominant form of credit purchasing. There will undoubtedly be a number of hiccups in the short term as the technology’s flaws are exposed. But ultimately, those same flaws are likely to be addressed and, in the end, just might make the average American’s wallet a safer place.

Resources

Iovation: The History of Credit Cards and How EMV Will Change Things

USA Today: Where is the EMV Card 10 Months Later?

CreditCards.com: 8 FAQs About EMV Credit Cards

Nerd Wallet: What Are the Downsides to EMV Technology?

Payments Source: EMV Tech in the U.S. Is Still Too Slow and Expensive

Gizmodo: How Criminals Can Easily Hack Your Chip & Pin Card

Computerworld: EMV Smartcards Offer Security Benefits Even Without PIN, Visa Says

Michael Sliwinski

Michael Sliwinski (@MoneyMike4289) is a 2011 graduate of Ohio University in Athens with a Bachelor’s in History, as well as a 2014 graduate of the University of Georgia with a Master’s in International Policy. In his free time he enjoys writing, reading, and outdoor activites, particularly basketball. Contact Michael at staff@LawStreetMedia.com.

The post Chip Cards: Making Credit Cards Safe Again? appeared first on Law Street.

Access to credit is a necessity for individuals who are faced with a sudden financial emergency. But for the “unbanked” and “underbanked,” there are very few options to get that access. To cover an unexpected expense, even a relatively modest one, that they can’t pay for with their savings or by selling something, these individuals often turn to payday loan providers. It’s an industry that generates billions of dollars a year and is characterized by many as being unconscionable. The interest rates on the loans are often as high as 400 percent per year (though the loans typically last two weeks) and users of payday loans are often trapped in a cycle of loan renewals that result in paying thousands of dollars to borrow hundreds.

High Interest Rates

The terms of payday loans are terms that most of us would never consider signing on for. An interest rate of 400 percent is by any definition, usury. But for the unbanked and the underbanked who desperately need that credit to get them through whatever emergency they are facing, those terms are agreed to. Contracts like this are sometimes referred to as “contracts of adhesion.” A contract of adhesion is one that involves a stark difference in the power of the two parties–where the stronger party is the drafter and the weaker party is unable to modify or negotiate the contract. Usually, these contracts are found in large transactions, like purchasing a house or a car. Courts are willing to take a closer look at these contracts because of the differences in bargaining power and if they find the contract, or a provision of it, to be “unconscionable” they will invalidate it.

The court’s ability to invalidate these contracts is meant to protect the weaker parties with little bargaining power. Just as stricter regulations on payday loan providers would be an attempt to protect the unbanked and underbanked from “predatory” lending practices. But calls for regulation do not address the underlying concern that if the payday loan industry were eliminated and nothing replaced it the unbanked and underbanked might actually be worse off than they were before. They would have no access to emergency credit. And while the majority of people who use payday loans get caught in a trap of debt some people are able to use these loans and benefit from them. If payday loans are going to be regulated to extinction or outright eliminated there needs to be some instrument for emergency credit to replace them.

By The Numbers: How Do PayDay Loans Work?

So what exactly are the terms of a payday loan? How bad are they really? Pretty bad, as it turns out. They are designed to not be paid back, which is why some states have banned them altogether. But that is, from the lenders’ point of view, the beauty of the system. Here is how it works. The borrower takes out a loan to pay off a debt. Often that debt is fairly small–the typical payday loan is for a few hundred dollars–and the term of the loan is usually two weeks. Borrowers often can’t pay back their loan within that two week period, which is not surprising given that they had no savings to fall back on, causing them to take out the loan in the first place. Borrowers then often end up “renewing” the loan. This is where loan providers make much of their money, from the frequent renewals. More than 80 percent of payday loans are renewed at least once and 22 percent are renewed six times or more, ultimately costing borrowers more in fees than the amount they borrowed in the first place.

Let’s use some of the numbers from Mehrsa Baradaran’s book “How The Other Half Banks” as an example. If someone takes out a loan of $325, a typical amount, and renewed it eight times (or took four months to pay it off) would cost the borrower $793. That number reflects a principal of $325 combined with additional interest of $468. In a very short time, the interest added up to almost 1.5 times the initial loan.

It actually gets worse. When the borrowers take out payday loans they sign over their paychecks or give a lender permission to withdraw money directly from their account. So when they get their paychecks the money they owe is taken directly from them, taking, according to a report from Pew Charitable Trusts, 36 percent of the borrower’s paycheck before they even get their hands on it to pay for other expenses–automatically.

Take a listen to this for an audio recap of how some of these numbers work out.

Given how high these interest rates are, what kind of borrowers would agree to them? It may not be the individuals you think. It isn’t the completely destitute who take out payday loans because they can’t offer their future paychecks to pay the loans back. According to a survey conducted by the Pew Charitable Trusts, “there are five groups that have higher odds of having used a payday loan: home renters, those earning below $40,000 annually, those without a four-year college degree, those who are separated or divorced, and African Americans.”

This PBS segment on the issue does an excellent job of showing the kinds of individuals who might take out a payday loan and some of the effects that it has on them and on society as a whole.

Unconscionability And Solutions

The numbers for the unconscionability argument against payday loans certainly seem damning at first glance. But just because the fees are high does not mean that they are unfair from an economic perspective. According to the economists at Liberty Street Economics, the unfairness argument shouldn’t necessarily depend on what the fees are but rather on whether those fees are being determined by a competitive market. A competitive market will produce a fee that is “fair,” but will still allow companies to cover the costs of doing business. One could make the argument that the costs of running this business are so high because these debtors are bad credit risks (likely to default) so higher fees are justified to cover the costs of those defaults. Providing credit isn’t a charity and we shouldn’t be writing policy as though it were.

Payday lenders will point to the high default rate on payday loans, and therefore the increased risk to the lender, as an explanation for high interest rates. If you look at the default rate for payday loans they are pretty high–studies in different states have found default rates of between 44 and 56 percent. This is not surprising when you are lending to a segment of the population that has no savings and limited access to banking options.

But the rate of default is more complicated for payday lenders. Payday lenders have the unusual and critical advantage of being able to draw funds directly from the borrower’s account.  This means that while the borrower may “default” because they don’t have enough money to pay back their debt in their account the lender can take the money anyway and subject the borrower to an overdraft penalty on their account. So the lender is still getting repaid even though they are categorizing it as a default. The Center for Responsible Lending calls this “Invisible Default.” In fact most borrowers (66 percent) who “default” actually do end up paying their debt back. The default rates on payday loans is often used to explain why lenders charge such high interest rates, but if lenders are still able to recover most or all of the money, these invisible defaults may not be as financial damaging as it may seem.

Potential Alternatives

There are several potential ways to reform payday loans but the two main ways, other than eliminating them altogether, are capping the amount of interest that can be charged and putting a cap on the number of times the loan can be renewed. A 36 percent cap is what is often proposed, but that is effectively viewed as a ban on payday lending, as lenders claim that they would not be able to cover costs. Even though 36 percent is much higher than the average credit card interest rate, the loan amounts are so small and the risk of default is so high that it probably would kill off payday lending, at least as it currently operates. A cap on renewals would also be costly for them but perhaps not to the same extent, depending on how many renewals were allowed per loan. If the number was very high it might not present much of a deterrent to either lenders or borrowers.

It is possible for a borrower to use a payday loan and not become ensnared in debt, as long as that borrower is able to avoid renewing that debt repeatedly. For those borrowers who need that credit and who believe they will be able to pay it back in two weeks, it seems unfair to eliminate their ability to borrow money at all. The inability of other people to borrow responsibly shouldn’t hinder their ability to enter into contracts that they think will benefit them, even if they end up being wrong.

The main premise for nullifying a contract of adhesion is that the parties weren’t on equal terms, and often, it is based on the notion that if the weaker party really knew what they were signing up for they wouldn’t have done so.  But in the case of payday loans, the borrowers do understand that they are signing a contract that is skewed entirely in the lender’s favor–the evidence suggests that they know what they getting into and are choosing to sign up for it anyway. Eliminating payday lenders without presenting another option is taking away their ability to make financial choices and preventing them from accessing credit.

The answer to an individual contract of adhesion may be to nullify the contract if there really is evidence of foul play and manipulation. But the answer to millions of those contracts isn’t to assume that each one was made by predators and prey. It’s to come up with a better kind of contract; one in which the terms are not seen as unconscionable by outside parties.

Borrowers are always going to need access to credit. Payday loans, as awful as they are, exist because that need is not being met by any other lender. But it could be–there are several different solutions to the problem of credit for the unbanked and the underbanked that we could implement here in order to eliminate the majority of the demand for payday loans. One such solution is one advocated in the book “How The Other Half Banks,” which is the institution (or actually re-institution) of the U.S. Post Office as a banking service. If you would rather listen to a discussion of the idea, you can listen to Mehrsa Baradaran, the book’s author, talk about it here. As discussed in both the podcast and the book, post offices reach even very remote communities and could be used as a place to deposit funds and could even be used to provide emergency credit.

Another solution Barandaran discusses is a British style overdraft where you are allowed to have a negative balance on your checking account (for an interest fee) without paying the high overdraft fees that many banks currently charge. If there were other options for borrowers who utilize payday loans to access the credit they need, such loans may not be necessary.

Conclusion 

Payday loans can be a spectacularly bad idea for borrowers, especially if they are not able to pay off their balance after the loan’s two-week period. The problem is that for the people who need them, a spectacularly bad idea may still be better than the alternative. The solution to the problem is not to eliminate a service, that despite its flaws may still be necessary, without replacing it. Rather a better solution for borrowers is to create an option, or a combination of several options, that gives them access to credit.

Resources

Goodreads: How The Other Half Banks

Pew Charitable Trusts: Payday Loan Facts and the CFPB’s Inpact

Liberty Street Economics: Reframing The Debate About PayDay Lending 

International Business Times: Payday Loans: Study Highlights Default Rates, Overdrafts As Groups Debate CFPB Regulations

Cornell Law School: Contract of Adhesion

Freakonomics: PayDay Loans 

SlateMoney: PayDay Loans, Postal Banking and Pre-paid Credit Cards

Huffington Post: PayDay Loans: The Worst Abuse is not Regulated

The Center for Responsible Lending: Payday Mayday: Visible and Invisible Payday Lending Defaults

Mary Kate Leahy

Mary Kate Leahy (@marykate_leahy) has a J.D. from William and Mary and a Bachelor’s in Political Science from Manhattanville College. She is also a proud graduate of Woodlands Academy of the Sacred Heart. She enjoys spending her time with her kuvasz, Finn, and tackling a never-ending list of projects. Contact Mary Kate at staff@LawStreetMedia.com

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