Wednesday, July 14, 2010

Credit Cards - How to handle a loaded gun

A credit card is a very useful thing to have, but very dangerous too.  You must surely possess a credit card; but do you know all that you need to know about it?  When you handle a gun, and a loaded one at that, you should be well aware of the mechanism and the safeguards for handling it.

Given below are some of the things you should always remember about that deceptively innocuous piece of plastic you carry around in your pocket.

Do you really need a credit card?

Yes, you do.  It is very convenient since you do not have to carry around too much cash.  It is also useful in an emergency.

Why do you need a credit card?

Not for credit, most certainly.  As we shall go on to explain, credit through a credit card is a certain road to financial ruin.  Shylock would blush in shame if he were to see the interest (and other sundry charges) we end up paying on our credit cards.

How many cards should you have?

Just one.    Ignore all the experts who give you advice on having multiple cards with multiple credit cycles; carrying out balance transfers between various cards, etc. 

The only exception could be where you carry a separate card for your corporate expenses.  In which case, in the interest of financial discipline, make sure you don’t charge personal expenses to the corporate card, and vice versa.  You might also just want to have a spare card as a backup.

What should be the credit limit on the card?

It is good to have a decent credit limit.  Just as it is good not to use the card for credit, but pay your entire bill in time every month.

What are the things you should check while applying for a new credit card?

Check for annual fees.  Most card issuers issue “free” credit cards today.  Ideally, there should be no annual fees.  Many cards that claim to be “free” charge you annual fees after the first year.

Check the lost card liability.  It should be “nil” after you inform the bank about the loss.  Be very careful on this point.  The last thing you want to pay for is someone going on a shopping spree at your expense.  From this perspective, you may also want to have a sanctioned credit limit that is not too high.  This would help you in capping losses in case of  possible misuse of the card.

Check the interest rate.  Actually, there is no need to.  Since you should not be carrying balances forward and paying interest anyway, it does not matter.  Anyway, while on the subject of interest, you know that the interest rates on credit cards are anywhere between 3%  to 4% per month.  That’s daylight robbery.  An interest rate of 3% per month translates to 42.5% per annum (it’s compounded monthly).  Assuming you pay tax on your earnings at 33% p.a., you need to earn 64% interest on your savings to compensate for this.  The interest on your savings bank account happens to be 3.5%; and one-year fixed deposits yield about 8%.

What is the arrangement between the bank and the merchant?

The merchant pays a commission (usually around 1.5% to 2%) to the bank.  Which is why, some merchants will insist on a 2% extra charge in case you pay by card.  Which is also why you pay a surcharge when you use the card at petrol pumps.  This commission is shared between the issuing bank (the bank that issued you the card) and the collecting bank (the bank from which the merchant collects the money).

What are the charges on a credit card?

Let’s assume that your billing cycle is from the 1st to the last date of every calendar month.  You usually get the bill by the 7th of the next month, and you have another 10 days to pay.  In case you pay in full, there is no interest charged.   Make sure you pay at least a couple of days before the due date, to give enough time for collection of the cheque and clearing.

You should ensure you pay in full every month, without fail.  Here is what happens if you avail of the revolving credit facility, and pay part of the balance.  The moment you have a balance on your card (even if it is Re. 1), you are on “revolving credit”.  Till such time as you clear your balance in full, you are charged interest on all carry-forward balances, plus on all purchases that you make from the date of purchase.  The clock starts ticking, and it’s a ticking time bomb!

In case you miss any payment due date, you are charged late payment fees.  You are also charged a fee (usually 2.5%) on cash withdrawals.  Interest on cash withdrawals is charged from the date of withdrawal, even if you have been paying fully on time; there is no free credit period here.  Never use your card for cash withdrawals.

There is a 12.36% service tax levied on all the charges levied on you like annual fee, penalties, etc.   That’s what you can call adding insult to injury.

Why do banks charge such a high interest rate?

Banks do this because the customers are not well informed.  They easily slip into the habit of carrying balances on the card.  And then find it difficult to come out of it.  The banks justify it by saying that they have to charge high interest rates to compensate for the high rates of default.  What that means is that you are paying for all the people who disappear without paying their dues to the bank.

What is “revolving credit”

This is the facility by which the bank says you need to pay only a part (minimum 5%) of the amount due, and carry forward the balance, at an interest rate of 3% plus.  If you do some math, you will figure out that the repayment period if you pay only the minimum amount, is close to your entire lifetime.

Why do banks want you to pay only the minimum balance and not the whole amount?

Simple; they are in the business of lending money – and credit card debt is a good debt to promote since the interest earnings to the bank are very high. 

If you already have high balances on your card, what should you do?

Beg, borrow, steal… from another source.  Or skip a few meals and save up the money to repay.  Take a personal loan from a bank to repay the card balances.  Card companies do give you the option, in many cases, to convert your purchases into EMI (Equated Monthly Installment) payments – beware of this option though – it is another ploy to get you into a long-term debt trap.  If you want to buy products on EMI, go for a regular consumer loan.

What should you do when you get an unsolicited add-on or supplementary card from the bank?

Cut it into four pieces and throw it into the dustbin.  You are not required to even inform the bank about it.

What about all the offers of discounts on shopping, hotels, travel packages, etc. that are available to you if you use your card?

Use the card, and avail the discount – but ensure you pay the bill in full at the end of the month.  Have you thought about the fact that most such discounts are available at high-end establishments where you anyway end up paying more for the same products or services?

Moral of the story: What should you resolve to do?

Never carry balances on your card.  Pay in full every month.
In case you have balances on your card – beg, borrow, steal – but repay – fast!
Use your credit card, not as a “credit” card, but as a convenient mode of payment.
Resolve never to borrow.  Borrow only for buying a house, or for saving your life!

(19 September, 2009)


SG said...

Very nice read. Thank you sir!

Pylichen said...

Excellent Article, Good awareness on how to use a credit card.

I loved the line. "What that means is that you are paying for all the people who disappear without paying their dues to the bank."

Well, thanks to your advice i have stuck to one credit card.

EMI info was good, but a question, if you have a single delayed payment but paid in full, does it mean that we lose a lot.


Dinesh Gopalan said...


you will pay interest for all transactions, including new ones, till you pay in full.