Venturing Out in the Credit World

The hidden cost of a credit card

By: Tavaga Research

We all know there is no such thing as a free lunch. When it comes to credit cards in our wallets, this could not have been truer. 

Credit cards come with an associated cost. But few elaborate on it. In public discourse, reams have been written on how convenient a product it is, instead.

But how many of us know the dark side of credit cards? The easy credit it makes available to us coupled with even the slightest financial indiscipline on our part can prove to be a dangerous cocktail that can harm us.

Credit cards have been around since 1981 when they were first introduced in India (by Andhra Bank). With four decades of credit card presence, most of us are aware of the basic concept — we spend now using it and pay the issuing bank back later.

But if we don’t pay up by the deadline, the consequences are not always palatable. Do all of us know what it means to miss a credit card payment even by a single day?

Many leading credit card providers in India provide an interest-free grace period, beyond the deadline,  to let us pay the dues without incurring extra charges. 

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Once the grace period is over, the penalty charges come barreling at us. Often, they are nothing less than exorbitant. First up, the late payment charges, going beyond Rs 900. 

Finance charges are charged next, chargeable monthly, which usually ranges between 3 and 4 percent a month. It translates into an effective interest rate of around 40-41% a year.

Let’s not forget the GST (goods and services tax) on these applicable charges, which is charged at the rate of 18 percent.

Unlike debit cards, cash withdrawals are discouraged on a credit card. There is no prolonged deadline nor an additional grace period for repaying the amount. The moment we withdrew cash from an ATM (anytime machine) using our credit card, finance charges are applicable from that day onwards. 

Then there are umbrella charges, applied irrespective of our credit card usage patterns. There is a joining fee and an annual membership fee.

Anecdotal evidence talks of people who have had to take personal loans to clear off their credit card debts. The irony is, as alarming as it may sound, a personal loan to pay off credit card dues is strategically far better than having to pay a hefty 40 percent interest annually to the credit card issuer.

Let us chart out here an illustrative example to explain how credit charges may snowball into large individual debt.

We assume the following rules (commonly applicable for most credit cards) for a regular credit card belonging to a person:-

1. The billing cycle is from the fifteenth of the month to the fourteenth of the next month.
2. The grace period is five days from the generation of the credit card billing statement.
3. The finance charge is 3 percent each month.
4. The charges of cash withdrawal are applicable from the date of the transaction, at 2.5 percent of the amount or Rs 500 a month, whichever is higher.
5. The minimum payment is 5 percent of the credit card amount due in a month (explained in detail further below).
6. The penalty for late payment (only till the next bill generation date) is Rs 800.

We are assuming the following transactions carried out by the individual in a month, say, June:-

• Purchases goods online on June 18 worth Rs10,000
• Is charged membership fees on June 25 worth Rs 500
• Withdraws cash to the tune of Rs 3,000 on July 12.

The person gets a credit card bill generated on July 14, as the billing cycle draws to an end, payable by July 19. 

The bill value? 

The amount payable will be Rs 14,000 (10,000+500+3000+500 {Penalty on cash withdrawal}).

The following will be his payment summary if he makes the payment on the dates (with respect to the billing cycle) mentioned below:-

Important Features of Credit Cards

Finance charges

Finance charges are the charges which the credit card company charges in case of non-payment of dues after the payment deadline. It is basically the interest charged on the credit card dues, which kicks in from the day we take the credit till the day we make the repayment.

Interest-free grace period

This is the period during which there is no interest levied on the dues. It generally ranges 20-50days.

Minimum amount due

This is one of the most lucrative features which a credit card-holder can have in a credit card, with them only paying a part of the total bill and rolling over the rest of their debt to the next month.

Credit card ownership then is fraught with debt pitfalls and makes for a far from the rosy picture.

We can sum up the ‘discredit’ in owning a credit card in the following ways:-

Disadvantages of a Credit Card

Overspending

Credit cards, take away the ‘pain of paying’ we often feel with other modes of payment. Deferring the erosion of our account balance when spending makes us often forget the weight of the action. While making life easier for a moment, credit cards meddle with our self- control instincts.

Even if we say that we pay our bills on time and incur no extra charges, there may still be an implicit cost in using a credit card.

Many studies report that people are willing to spend more than they usually would, and at times, beyond their reasonable means, with a credit card because they don’t feel ‘the pain of paying’.

Credit card fraud

Credit card-related frauds in India are on the rise. After the controversial demonetization move, there has been a substantial rise in credit card-related transactions, which makes it easier for fraudsters to copy the credit card data and scam the card-holder. 

India was ranked among the top five countries with regard to credit card fraud, with more than one-third of those polled saying they had been scammed, according to the 2016 Global Consumer Fraud Report published by payments technology company ACI Worldwide.

Interest and fees

Using a credit card is essentially borrowing money, and if we are not disciplined in timing our repayments, we may get crushed by the interest expense and penalties levied by the credit card company.

The Credit Card Debt Trap

If we have our backs to the wall with credit card debt, we may take a loan to pay back what is essentially a costlier loan. But that is not a win. We would get ourselves mired in the vicious circle of a debt trap.

The new-age millennial does not shy away from taking loans for fulfilling their discretionary needs. With the advent of NBFCs, there is no dearth of easy credit (instant-loans, for example) but all of it comes with a heavy interest rate.

The problem starts when it is time to pay it back.

The debt trap snares its victims in many unsavory ways. Some of which are:-

1.     Taking another loan with a lower interest rate to repay an existing loan.

2.      Keep on paying the high interest on an existing debt/loan.

3.       Defaulting on the existing loan.

The first option might help us get back on track if we settle the second loan.

The second one might not be viable as the interest charged on these loans may be as high as 40 percent a year.

The consequences of the third option can be severe, as the recovery process by the issuer is strict. In this credit card companies are not lenient either. Playing their role as the loan-issuer, they can deploy hostile measures. Our credit score takes a severe hit and it would be near impossible to bring back our credit score to the levels at which we can take another loan.

How to avoid the overwhelming debt trap

Here are a few pointers:-

·      The priority should be to keep our expenses below our income, budgeting our finances.

·         Use the credit card only in case of emergencies (helps in urgent hospitalizations, for example).

·         Create an emergency fund for contingencies, to avoid using credit cards.

·         Paying off our debts with the highest interest first.

Financial Awareness

Financial planning has become a challenging task in this century. Why? Because there is always something fancy and new that keeps coming up and the temptation to spend is difficult to overcome.

The smart thing to do would be to break the chain of debt or the urge to borrow and move more towards financial freedom, no matter our income.

The first step would be to save enough to start investing. One of the best ways to overspend and avoid a debt trap is hiding our money from ourselves.

There are many ways to invest even a small amount of money, from fixed income schemes to equities. 

However, one of the more rewarding (and riskier) routes — equities — is also fraught with challenges.

As we all are busy in our day to day lives, we may not have the resources to intensely track the financial markets, like reading every financial news source out there. 

But without deep understanding, we may burn our fingers by investing in a company’s stock. 

There may be a way to work around it and still invest in a good-returns mode of investment. Passive investing, for example.

Passive investing has largely been the unsung hero in investing in India so far. In other parts of the world, retail investors have woken up to its benefits. 

Passive investing lets the market perform without any active meddling, and reaping the rewards over time. Passive funds have performed better not only for Indian schemes but also for international schemes.

10-Year Performance of Motilal Oswal Nasdaq 100 ETF (Passive) and Edelweiss US Value Equity Offshore Fund (Active)

It invests in the performance of exchange indices such as Nifty or Sensex, without churning our portfolio by constantly buying and selling stocks of companies. One of the methods to passive investing in equity and debt is through the Exchange-Traded Funds (ETFs).

5-Year Performance of the ICICI Prudential Sensex ETF

1-Year Performance of the Bharat Bond ETF – April 2030

So, if we want to bring in financial freedom without turning to debt, investing, and passive investing at that, can be an answer.