We have spoken at length on these pages about the importance of avoiding credit card debt. Today, let us delve a little deeper into the subject and try to understand what a credit card is, why thoughtless use of it can be dangerous, and why the word ‘trap’ is used in the headline of this article.
First of all, let us try and understand what a credit card is.
Most of us are familiar with two types of ‘plastic money’. One is a debit card and the other is a credit card.
What is the difference between the two?
A debit card is nothing but a method to access your own money. It is like a key to your bank, as it were, enabling you to withdraw your money at an ATM or use it to pay your bills. At no time can you spend more on a debit card than you have lying in your bank account. Though limited by daily limits on withdrawals that are in place for security purposes, in principle you can take out as much money as you have in your account.
By contrast, a credit card is not linked to any account you hold. When you use a credit card, you are spending money you are actually borrowing from the card-issuer company. This is a short-term loan, and you are required to repay it, either in full, or by instalments, over a period of time. As with any loan facility, a limit is set on how much you can spend using a credit card, which you may not exceed.
So a credit card, then, gives you access to borrowed money. It sounds like a pretty sweet deal, does it not? Spend, using someone else’s money. Pay it back when you can. Credit card companies do not ask for ECS mandates to take your money in instalments. They will not even ask for post-dated cheques. Use the card, and repay when you want to.
If that sounds too good to be true, that is because it is. Nobody gives a loan without charging interest for it. What is the interest rate on the credit card then? Ask the salesperson trying to convince you to buy one and you will get an answer that sounds unbelievable. 2.49%, he will say, or sometimes, 2.99%
When your home loan will be at an interest rate of 10-12%, your car loan at a little more than that, and personal loans at even more than that, this sounds tremendously low.
That is because your friend forgot to mention that the interest rate he mentioned is on a per-month basis. That’s right. So 2.49% becomes 29.88% annually, and 2.99% becomes 35.88%.
Sounding scary? That’s because it is.
Add to that late charges for missing your payment due date, processing charges for accepting payments in cash, and ‘over-limit’ charges for spending above your approved limit (yes, upto a certain point, the credit card will let you use more than your actual limit, and then charge you for it, rather than rejecting the transaction).
Another insidious trick used by credit card companies is to show a ‘minimum payable’ amount. Many customers think that paying this is sufficient to avoid the heavy interest charges and other costs. In fact, by paying only the minimum payable from month to month, they think they are remaining financially solvent while keeping their expenses to a minimum. As a matter of fact, the ‘minimum payment due’, is merely the amount to be paid to avoid being treated as a defaulter. That very-high interest rate will be charged on your amount outstanding all the same, whether you pay the minimum amount or not.
Does any of this mean that credit cards should not be used at all? I would say that is not the case. Responsibly used, credit cards are not in themselves harmful. Carrying large amounts of cash is not feasible, and most shops and hotels no longer accept cheques. Many of us, keep a low balance in our savings accounts, preferring to quickly invest our money. Sometimes, an unexpected expense could mean a shortage of bank balance that needs to be tided over. In such cases, credit cards do provide the easiest access to short-term credit. For buying of white goods, electronics and so on, it does make a lot of sense to plan your payment using a credit card…
Provided you have the money to pay your balance on the due date.
This is the single most important thing to remember when dealing with credit cards. Whatever be your card outstanding, pay it in full on or before the due date. (In fact, given that cheques and ECS take a few days to clear, it is better to err on the side of caution and try to ensure the payment is made at least 5 days before the due date. The moment you are late on a payment;
- Late payment charge
- Interest on outstanding amount begins to accumulate.
So be aware of your payment due dates. If possible, set up a standing instruction to transfer the full amount due from your bank account to the card company well before the due date – and ensure your bank is funded for the amount.
It is that simple – and that difficult. There is no other way, short of not taking a credit card at all.
If you find you cannot trust yourself to follow this advice with a religious zeal – you have fallen into the Credit Card trap – and that’s a hole it is very difficult to dig your way out of.