How to avoid Credit Card Trap?

Don’t fall into the Credit Card Trap

Recently, I met Mr. Suresh who got married in last June and spend lavishly for his marriage purchase using the credit card. Total due on his card was 1 lakh after the marriage, but he managed the card by paying the minimum amount due. After marriage, he was using the card for honeymoon expenses and to pay for the increased household expenses. Last month, Suresh met me telling that the huge outstanding on card is increasing month after month even after paying the minimum due every month. Suresh is the representative of the modern credit card customers, who use the card and trapped in it.

Credit card is a small plastic card that fits exactly into your wallet and is an integral part of every man’s life these days. Credit card companies are competing to sell their cards to a new recruit to even a retiring employee and by all chances, you will get your first credit card barely days into your first job. Most people don’t know much about what a credit card is, but they will learn about it in the hard way. This article is to explain about credit cards and the way people use or misuse it and cause financial chaos to them.

What is a Credit Card and how it works?

A Credit Card is an agreement between a lender – usually a bank or a financial institution and a customer- like you and me who purchases the credit card wherein the lender issues you a  credit card which has a specified limit up to which you can spend using the card. The limit will be decided by considering many factors like your credit history, income level etc. The lender will generate a monthly bill and you pay him what you used the card for in the entire billing period at various merchant’s outlets. It’s pretty simple. This avoids the hardship of carrying cash at all merchant outlets.

Let us explain with a simple example. Mr. A, a software engineer gets a credit card from XYZ Bank with a limit of Rs. 1Lakh (It means he can spend up to Rs. 1Lakh using his card).He takes his family out on 3^rd March for shopping and get a LCD TV for Rs. 25,000/- and enjoy a nice family dinner at a restaurant for Rs. 2500/- . Next month bank generates the bill statement which has the following basic information.

Statement Period – The dates for which the statement is generated. Ex: 01-March-2011 to 31-March-2011
Statement Date – The date on which the statement is generated. Ex: 01-April-2011
Due Date – The date before which we must make the payment to the bank. Ex: 12-April-2011
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 policy and your total outstanding in the card.

Now Mr. A sends a cheque for Rs. 27500/- on 5th April.2011 and there ends the matter. Mr. A has used the card only to avoid the pain of carrying cash to different outlets and he settles the entire amount due in the card before the due date. He got a free credit of more than a month to pay his bill.

How the bank can afford this? Where is the debt trap?

You must be thinking by now, if it were so simple why many card users are getting into the credit card trap. The second most important thing running in your mind is why banks are running around in all cities selling credit cards like hot cakes? How do banks make money out of this?

Bank is getting income from different sources.

1. Annual Membership Fees – most cards these days are free for life but certain high privilege cards come with an annual fee.

2. Merchant/Seller Commission – Every time you swipe your card at a shop for Rs. 100/- the bank will credit around Rs. 98/-only into the merchants account. They will keep this Rs. 2/- as fee which the merchant has to bear in order to have a credit card reading 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 again take the example of Mr. A

Mr. A received his bill with minimum amount due as Rs. 500/- and total amount due as Rs. 27500/-.Due to cash shortage Mr. A opts to pay only Rs. 500/-.Now  he has successfully entered the credit card debt trap. Let us see how.

Credit cards usually charge customers an interest of 2.5% or more per month (annualized interest of more than 40%) Here Mr. A paid only Rs. 500/- So this is how the finance charges work out. Interest on outstanding Rs. 27,000/- for one month: Rs.675/-
So essentially, the next months due amount for Mr. A would be Rs. 27675/- 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. A bought some other stuff for Rs. 10,000/- this month then his finance charges would be Interest on Rs. 37000/- for one month: Rs. 925/- (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. 37925/-

This is something that not many people know. Now you know how banks can afford to spend so much money in marketing credit cards. Once you started paying only the ‘minimum amount due’ and enter the credit trap, whenever you use the card it carries interest from the date of purchase. No interest free credit will be given to those customers and this is the main income for the banks!

Withdrawing Cash from a Credit Card

This is the biggest mistake we do. The card seller gives us a PIN number and tells us that we can withdraw cash from the card up to a certain percentage of our credit limit for our urgent requirements. 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 charging interest on the amount withdrawn from the minute you take it out of the ATM.

Should we use Credit Cards?

I 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 example, co-branded cards give you around 2% discount. You get free credit points depending on your spending and these points can be exchanged for gifts or to adjust against your future bills.

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 Trap:

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 at the earliest to avoid paying too much interest to the bank.

2. If you have not paid your card due in full this month, avoid using it for fresh purchases.

3. Keep track of your spending. Keep 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. Don’t withdraw cash from your credit card unless it is on medical emergency.

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.

Credit Card is a wonderful product which is helpful to meet any contingencies and will offer the benefit of free credit from the date of purchase to the due date. Accumulated reward points also will be useful. But if we start paying the minimum amount due and keep spending on the card like Suresh, it will be difficult for you to get out of this trap. It is better to avail a personal loan or Gold loan and close the outstanding on the card at the earliest.

Also be aware of the Recovery Agents from the banks.