Thursday, September 9, 2010

Don't fall into the Credit Card Trap

A credit card is a small piece of plastic paper that fits exactly into your wallet and is an integral part of every man’s life (these days) my dad never knew what a credit card is or what it does when he was working for more than 25 years and earning for his family whereas I got my first credit card barely weeks into my first job. I dint know much about what a credit card is when I got it but I sure did learn about it the hard way. I have been wanting to write about credit cards and the way people use or rather misuse it and cause financial chaos to themselves for quite sometime. I guess its time to put my thought into action. Ok, let’s get started.

What is a Credit Card?

A Credit Card is an agreement between a lender (usually a bank or a financial institution) and a customer (you & me) wherein the lender issues you a card which has a specified limit upto which you can spend using the card. The lender will generate monthly bill statements and you pay him what you used the card for. It’s pretty straight forward.

Note: Credit Cards are a form of Revolving Credit which is used in Business/Industrial terms.

How does it work?

Let us explain with a simple example. Mr. X gets a credit card from ABCD Bank with a limit of Rs. 50,000/- (It means he can spend up to Rs. 50,000 using his card) In the joy of getting his card he takes his family out shopping. They get a new TV for Rs. 25,000/- and enjoy a nice family dinner at a restaurant for Rs. 2500/- and is back home. The next month ABCD Bank generates his bill statement which has the following information.

Statement Period – The dates for which the statement is generated. Ex: 01-July-2010 to 31-July-2010

Statement Date – The date on which the statement is generated. Ex: 01-Aug-2010

Due Date – The date before which we must make the payment to the bank. Ex: 08-Aug-2010

Total Amount Due – The total amount you owe the bank. Here it is Rs. 27500/-

Minimum Amount Due
– This is the minimum amount you need to pay the bank to avoid your card being blocked. Usually it is Rs.500/- or an equivalent amount based on the bank.

Now Mr. X sends a cheque for Rs. 27500/- on 4th August 2010 and there ends the matter.

How can Credit Card Company’s afford this?

You must be thinking by now, if it were as simple as I had explained in the first few paragraph’s people wouldn’t be burdened so much with their credit card debts. The second most important thing running in your mind is, why are banks running around in all cities selling credit cards like pastries? Why are there people standing outside every single company in India selling their bank’s credit cards? How do banks make money out of this?

Am I right? – I believe yes… read on for the answer.

Income for the Bank through Credit Cards is multifold.

1. Annual Membership Fees – most cards these days are free for life but certain high privilege cards like Platinum or Titanium cards come with an annual fee.
2. Merchant/Seller Commission – Every time you swipe your card at a store for Rs. 100/- the bank will credit only Rs. 98/- into the merchants account. They will keep Rs. 2/- as convenience fee which the merchant has to bear in order to have a credit card reading POS machine on his billing counter
3. Finance Charges paid by customers.

The third point needs to be looked in a bit more detail. Let us take the example of Mr.X and his shopping spree.

Mr. X received his bill that states minimum amount due as Rs. 500/- and total amount due as Rs. 27500/-. Let us say, due to cash shortage Mr. X opts to pay only Rs. 500/- he has successfully entered the credit card debt trap.

Credit cards usually charge customers an interest of 2.5% or more per month which annualized is more than 50% in a year.

Here Mr. X paid only Rs. 500/- So this is how the finance charges work out.

Interest on Rs. 26,500/- for one month: Rs.662.50/-

So essentially, the next months due amount for Mr.X would be Rs. 27162.50/- which is more than the money he used in his card. This is assuming he did not swipe his card for further purchases this month.

Assuming Mr.X bought some other stuff for Rs. 10,000/- this month then his finance charges would be

Interest on Rs. 36,500/- for one month: Rs. 912.50/- (If you have an existing balance on your credit card and still continue to use it, the bank will charge you an interest on the newly swiped amount too)

So essentially, the next months due will be Rs. 37412.50/-

This is something that not many people know. Now you know how banks can afford to spend so much money in marketing credit cards.

A Nail in the Coffin:

If you swipe Rs. 10,000/- on your credit card that charges you 2.5% interest per month and continue to pay your minimum payment due which is Rs. 500/- every month, you will be paying for the next 40 months and a total of Rs. 20,000/- before you finish repaying the debt of Rs. 10,000 you got from the bank.

Withdrawing Cash from a Credit Card:
This is yet another mistake the layman does. The card seller gives us a PIN number and tells us that we can withdraw cash from the card till a % of our credit limit for our urgent requirements. To hear it is good but once you withdraw cash your story is over. The bank will charge you a few hundred rupees for providing you with access to the ATM and instant cash plus you start paying interest on the amount withdrawn from the second you take it out of the machine.

If I withdraw cash Rs. 10,000/- from my credit card today morning at 9 AM and return it before 5 PM today I will pay at least Rs. 10,300/- or more. This extra money includes the charges to access the ATM and the interest. This again is a big NO NO for credit card users.

Should we use Credit Cards?

Am not advising against use of credit cards. Most credit cards come with great offers and benefits and it would be foolish on our part to miss out on them. For Ex: Indian Oil co-branded cards give you a 2% discount on fuel everytime you use it to pay your fuel bills. If you are someone who fills fuel for Rs. 10,000/- every month, you save Rs. 2400/- in a year. Which is a good saving.

So the point is – Use your credit card wisely and follow the below tips to stay away from credit card tips.

How to stay away from Credit Card Debt:

1. Repay your due amount in full every month. If you do not have enough to pay off your card bill in full, pay as much as you can. Don’t stick to the minimum amount due. Try to pay off your card due amount within 2-3 months to avoid paying too much interest to the bank
2. If you have not paid your card due in full this month, DO NOT use it for fresh purchases
3. Keep track of your spending. Saving the receipts of credit card swipes is a good way to start. You can reconcile your spending at the end of every month and check if it tallies with the card statement
4. DO NOT withdraw cash from your credit card
5. If you are not able to control your card usage, switch to using your Debit card. It is similar and much safer than credit cards because you cannot overspend.

Happy Spending!!!

1 comment:

  1. A card that can be used repeatedly to borrow money or buy goods and services on credit. It is issued by banks, savings and loans, shops and other businesses.
    Membership card printing


© 2013 by All rights reserved. No part of this blog or its contents may be reproduced or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the Author.


Popular Posts

Important Disclaimer

All the contents of this blog are the Authors personal opinion only and are not endorsed by any Company. This website or Author does not provide stock recommendations. The purpose of this blog is to educate people about the financial industry and to share my opinion about the day to day happenings in the Indian and world economy. Contents described here are not a recommendation to buy or sell any stock or investment product. The Author does not have any vested interest in recommending or reviewing any Investment Product discussed in this Blog. Readers are requested to perform their own analysis and make investment decisions at their own personal judgement and the site or the author cannot be claimed liable for any losses incurred out of the same.