Monday, February 4, 2008

Use credit cards prudently never roll over balance

Those who have become servitude to plastic money and easy availability of collateral-free credit should beware! Failing to realize the cost of suggestions of using credit cards — be it for purchases, cash withdrawals or taking a loan — can get you caught up in debt.

The problem is so tormenting that early last week the State Bank of India started a campaign program to educate people about the financial risks of high interest rates on credit cards.

All over the world people are falling into this debt-trap time and again. There have been large-scale payment defaults by credit cardholders in Hong Kong in 2002, in Korea in 2003 and in Taiwan in 2006.

In the late 1980s US was also engrossed by a similar situation during a savings and loan crisis. In recent times, the sub-prime mortgage problem in the US is falling over to credit card payments.

According to the Reserve Bank of India data banks and non-banking financial institutions have issued 2.59 crore credit cards till November last year. Between April and November, payments worth Rs 48,746.17 crore had been made through credit cards.

However spending by using the plastic is only 2.7 per cent of the total personal consumption expenditure, while retail credit has gone up to one-third of the total bank credit in the country. It shows that people are now more burdened with financial liabilities therefore are more prone to financial risks.

Hence, it can be disastrous to use the plastic unwisely without a proper understanding of how interest rates for debts on credit cards are calculated and of one’s repayment capability after servicing other loan liabilities.

Often card issuers do not explain elaborate interest calculation to customers, adding to their misery.

Tapas Kumar Deb, a 55-year-old resident of Beleghata, has been holding an SBI credit card for the past eight years. In December 2006, he finally gave way to persistent calls from SBI Credit Card telemarketers for a personal loan at a monthly interest rate of 1.5 per cent that the bank had pre-approved considering his good repayment history. Deb needed the money for a heart surgery.

His nightmare began a few months after he started repaying the equated monthly installments (EMIs) for the loan.

“They charged me an EMI of Rs 2,481.11 for the Rs 58,000 loan that I took for three years,” Deb said. “Even at an annual interest rate of 18 per cent, the EMI should have been Rs 2,097. When I enquired, they said it was a “flat” interest rate. Anyway, I decided to prepay the loan.”

Deb’s prepayment will not be easy. He will have to pay a 3 per cent penalty on the outstanding loan.

With a flat interest rate, the EMI is obtained by calculating the simple interest on the loan and then dividing the amount (principal plus interest) by the number of months for which the loan was taken (see table 1).

One thing to be taken in consideration is in this method the interest is calculated on the entire loan amount and for the entire loan period. It does not include the principal repaid during the repayment period. Therefore, under the flat interest calculation one continues to pay interest on the principal that has already been repaid.

Therefore, if you take a loan from a bank, interest will be calculated under the reducing balance method (see table 2). It means, you will not have to pay interest on the principal being repaid and on the same loan you would have to pay an EMI of Rs 2,097 instead of Rs 2481.11 under the flat rate.

In case of a credit card loan, if you are unable to pay your bills on time, you will be charged with a punitive interest rate and a late payment fine that a bank loan generally doesn’t attract. Higher rate of interest will be charged on cash withdrawals or loans on credit cards than purchases on the same card.

Till the time you do not rotate debt on your credit card, it is worth using. But if you decide to pay the minimum due to be paid against a credit card bill, you will be in a soup.

For example, if you spend Rs 50,000 on a credit card that charges a monthly interest of 2.85 per cent and pay only the minimum 5 per cent of the due every month, it will take you around 12 years to fully repay the dues (See table 3).

Besides, the interest you will pay will be nearly Rs 58,000 which is more than what you had originally borrowed!

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