Using credit wisely

Published in The Hindu - Sunday Magazine on Jul 6, 2008

Despite the high risk of debt trap posed by credit cards, I am an optimist who believes that access to credit in a convenient, card-based form is probably the strongest economic catalyst in India, next only to the mobile phone. The wonderful thing is that both have become equaliser of sorts, with access extending from the CEO to the self-employed. On a more serious note, the credit card has helped cure my backache, caused by a bloated purse. Of course, the unintended side effects are on the rise — e.g. I have forgotten how to count “change”, soon I expect to forget how to buy a ticket — what with the co-branded credit card that doubles up as the Delhi Metro pass.

Let me discuss the interest charge on credit cards this week using the habits of two personalities. The first person is my cab driver. He regularly uses his card during the month to pay for his key operating expense, fuel, so that when he receives his payment the following month, he can clear the bills on the card — in effect making his card a source of interest-free working capital loan.

Misconception

The second gentleman, an erudite relative, uses the credit card for occasional purchases (obviously attracted by its convenience and safety) but sends a cheque to the card account after every purchase! When I enquired the reason for his rather strange practice, he claimed that the interest rate on the credit card starts ticking from the day of purchase! Does it? At least, not for the person who pays the full amount on the card bill. In this case, your credit card allows you to spend for a whole month, after which you get your statement and an additional 20 days to settle the bill with zero interest applicable (a free credit). A smart credit card user pays his bill in full but close to the due date, so that he is not charged a penalty, while at the same time he can save the interest cost of an entire month’s expenses. People who invest their capital in a business or otherwise, can easily earn 1-2 per cent return during this 50-day window of delay offered by credit cards.

So, when does the credit card stop offering free credit? Or alternatively, under what condition is the interest charge levied on your credit card from the date of transaction?

a) Cash withdrawal: Most credit cards offer a separate “cash withdrawal limit”, which is a subset of your overall credit limit. This feature is unlike your regular credit card usage and has entirely different set of terms, which make a strong case for staying away from the facility. Firstly, there is service fee, ranging from 3-5 per cent, with a minimum of around Rs. 500 that is charged upfront whenever you withdraw cash on your credit card. Secondly, the interest rate levied on cash withdrawal could be higher than the interest rate on your regular revolving credit. Also, the interest charges will start ticking from the day of the transaction (unfortunately favouring the paranoia of my erudite relative). In addition to these penalties, a further blow comes from the fact that repaying cash withdrawal is not that simple. For example, if you made purchases worth Rs. 10,000 on your credit card plus withdrawn cash of Rs. 5,000 during a particular billing cycle, your cash withdrawal will not be settled unless you pay the entire balance of Rs. 15000. i.e you cannot settle the higher interest cash withdrawal separately. Given the various conditions surrounding cash advance on credit card, it is a much cheaper idea to take out a personal loan, unless you are in a dire emergency.

Pay in full

b) If you don’t pay your balance in full: Assume that your card statement is generated on June 18 with July 8 as the due date for payment and you decided to pay only a portion of the total outstanding. Then the interest charges in your next billing cycle (on July 18) will be calculated on “all unsettled transactions” from the date of transaction occurrence — not only for those spends in the previous billing cycle (going back to May 18) but also for the fresh spends in the new billing cycle (starting from June 18). With this harsh logic and a typical monthly interest rate of 3 per cent charged by card companies, if you keep paying only the minimum due on your credit card (usually 5 per cent of total outstanding or Rs. 200 whichever is higher), it would take 13 years to pay off an outstanding balance of Rs. 50,000 and you would have paid Rs. 71,000 in interest alone!

Whether you want free credit or expensive credit is for you to decide, but the credit card is here to stay.