When I say credit card, what are you reminded of? I have come across people who quite often people anxious to use a credit card. I know few friends who think owning a credit card is extremely bad. So, is it good to have a credit card? This is a bit complicated question to answer. My short answer to this question would be, if you are able to manage your expenses and plan your budgets in a disciplined fashion, then credit card is a must have. This is a powerful tool that can be used to your benefit but at the same time, carelessness can hurt too. So fundamental thing to remember is your Need.
WHAT IS A CREDIT CARD
Let me admit, credit card is one of the complex products invented by mankind, next only to an Iphone which is supposed to have more computing power than the machine that took Neil Armstrong to the Moon. But if you master the rules of the game, all the complexities look simple, or say, greatlysimplified! Basically, credit products can be broadly classified into two types – Loan and Line. In the earlier post, we greatlysimplified the rules of loan products. We discussed Home loans and Personal loans. If you have not still read the same, please see here. Beware you may come across more plugs than a spike board can accommodate. Back to the subject, Loans are fixed amount given for a fixed period during which you pay monthly installments. At the end of the tenor, the total outstanding becomes zero because you paid up. In the monthly installment that you paid, there is an interesting component for the principal for the month and it keeps going down as per your payment.The other type is called a Line. This is a facility the banker has offered you based on your credit worthiness and it can be used (drawn) as per your requirement. You only pay charges for the period that you have used. Of course there may be a nominal annual fee for the facility that you may be charged, with GST of course! There are various types of lines and this is quite prevalent among businesses where there are such facilities available for managing their working capital. Here let’s delve deeper into Credit cards.
BUT I AM ASKED TO PAY ONLY A SMALL AMOUNT EVERY MONTH
Those of you who already have a credit card would have noticed on your statement a total outstanding and the due to be paid by a due date. Have you ever wondered why you are not asked to pay the entire usage and square up? You may note here that there is a variant of credit card called charge cards, where you are expected to pay the entire due. Presently we are looking at the general credit cards that all of us have. You are not explicitly asked to pay the entire due because that’s how the credit card company earns money. What you are asked to pay is actually called a Minimum Due. This is the threshold paying which, you will be allowed to continue to use the facility. Any amount lesser than this or any miss in this payment would make you delinquent on the account. Yes, you are welcome to pay any amount higher than this minimum due.
IF I PAY MINIMUM WHAT HAPPENS
If you pay the minimum due on the card, the bank will charge interest on the remaining amount till the next billing period. Different banks follow different methods to calculate the minimum due and it also varies by country. There are countries that have mandated a certain percentage as minimum due. But mostly it may be about 5% of the principal balance that will be billed as minimum. Any other charges including interest charges, may be over and above this. To understand the way this is done on your credit card, do read your statement in detail, you’ll be able to understand this very clearly.
Essentially once you pay the minimum balance, you’ll be charged interest on the balance principal outstanding on your next statement. This will continue till you pay up the 100% of the balance on the credit card including any fees or charges. The interest rates charged on a credit card are quite high compared to any other loan. This is because the bank is issuing this facility to you for a really long period of time without any security to back the exposure. The actual interest rate on a credit card would vary depending on your relationship with the banker and the credit behavior. In India, typically you’d notice monthly interest rates of about 2.5-3.5% taking the annual effective rate to be about 35+%. Look at your statement closely to understand how much of interest that you are charged, it could be lower or higher than this range as well.In India, GST is charged on the interest component, taking the effective cost much higher.
Let’s assume you need to pick up the new Iphone Max without selling a kidney, you can either swipe the card for 100,000/- or take a Personal Loan. Assume Card charges you 3.5% per month and you pay 5% of the balance and square off on the 12thmonth. Similarly, the Personal Loan is at 15% annual charge where you pay an EMI for one year. This is what it looks like.
ALL PAIN, NO GAIN?
Credit card comes with quite a few advantages. If you route all your monthly expenses through your credit card, the reward points accumulated can actually grow into a significant chunk. I know of friends who squeeze out a domestic return air ticket out of the rewards every year. Of course this is dependent on your usage. This is a powerful tool that is usually missed out due to extreme conservative approach towards credit. You also get a lot of offers when you use a card. Do a bit of looking around before making any purchase. You could actually eke out about 5% savings on your mundane grocery purchases.
One of the important benefit that usually people miss out is a disciplined behavior on credit card is a powerful tool to build a profile on the credit bureau. While you may choose to ignore the world of credit, trust me, you’ll need it at some point in life and it is important to have a good credit bureau record.
BUT INTEREST RATE IS HIGH
A significant benefit is a period of free credit that you get. You need to remember two dates when it comes to a credit card – The statement date and the payment due date. Any purchases from the statement date till the next payment due date is literally available to you at free of cost. For eg., assuming your statement is generated on 15thof Aug and the same day you made purchases worth 100,000/-, this will be billed to you on your next statement on 15thof Sep for which the payment will be due by 30thof Sep. In this case you have enjoyed 100,000/- credit without any charges for 45 days. Important word of caution here is that you need to paying 100% dues in the past, present and in future. If you delay or make a reduced payment, then you’ll need atleast 2 month to get back on track. So, if you plan your finances well, you can really get the most out of a credit card.
The key is to pay 100% within the due date and in case for some reason you need to pay only partial, square off as soon as you get money. If you pay 100% of every month’s bill, you actually are getting credit without interest. Let me assume that you are able to invest the amount for the 45 days’ period for a return of investment of 12%. Actually you’ve earned money by using a credit card.
IF IT IS SO EASY WHY DO PEOPLE CALL DEBT A TRAP
Usage of credit needs to be a very prudent decision. You need to have an extreme control over the way money moves in and out of your account. Some of the common mistakes that I have seen leading people to a trap are:
Bank has given me a good limit so let me go and swipe – The limit is provided after various careful considerations. It is easy to go and swipe for the entire limit. You need to be very sure your monthly cash flow and the ability to pay before using the card.
What to do? expenses are high and cost is increasing – most of the expenses that we incur are for social gratification and to satiate peer comparisons. Why do you need to upgrade your phone when the earlier one’s EMI is still running? It is important to get a grip of the monthly inflow and outflow.
It is very complicated to calculate – when it comes to your vehicle, you end up cleaning it every day and your heart misses a beat when there is a scratch on it. Why can’t we just look at our financial status on a regular basis and make a plan. Except gravity, nothing can happen without an effort.
Rotating loan payments – this is a classic case where I have noticed people borrowing from one place to pay another. Unless you are in a deep mess with your financial condition, do not do it. Make a list of your loans in the descending order of their interest rate and start paying them one by one. Simple rule, if you have any loan that is at a rate higher than your rate of return, you need to close it. Don’t expect to be Preeti with investments in FD and a personal loan running! If you didn’t get who Preeti is, see here
The bank puts hidden charges – this is one of the silliest comments I have heard. Believe me, no bank adds any hidden charges. You spend almost 1 hour to get the perfect pair of jeans, why would you ignore reading the terms and conditions before taking a loan or a card? It hardly would take 10 minutes. Do not just sign some random papers and give to a sales executive. Read the charges and take an informed decision. Write it down somewhere for future reference too.Have you heard of the well of death? The performer drives a vehicle along the inner walls of a well and comes out unscathed. Using credit is quite similar, you can get in and get out and keep riding till you have 100% control. The moment you loose control, call someone for help!
This is not an investment advisory. The intent is to simplify investment related concepts. Please seek professional advise before investing! Views expressed here are personal.