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Why credit cards burn a hole in your pocket

Do your bit for society, use plastic!' reads a very cleverly-worded advertisement that encourages you to spend using your credit card where the card issuer promised to contribute a sum to a well-known charity if you spent money with their credit card.

The bank also makes it very convenient to pay off the money thus spent in easy installments by allowing you to pay up only 5 per cent of the total amount due. The only fly in the ointment is the interest rate that the bank charges if you do not pay off the full amount on or before the due date.

The average interest rate charged on the amount revolved (that is banker-speak for the amount allowed to be rolled over and paid later) is around (hold yopur breath!) 34 per cent per annum. Yes, you read it right and there's no printer's devil here!

I am sure you have wondered why the average rate of interest on credit card is around 34 per cent per annum when the average rate on a home loan and personal loan is around 10 per cent per annum and 18 per cent per annum respectively. There are several reasons for this sharp difference in interest rates between the products.

Why credit cards burn a hole in your pocket

One reason for the huge difference in interest rates between a home loan and a credit card is the higher risk of default that the bank carries due to the completely unsecured nature of the credit card product. Around the world, the interest rate on a credit card is significantly higher than a home loan.

For example, in the US, the current average interest rate for a 30 year fixed rate home loan is around 6 per cent whereas the average credit card interest rate is around 14 per cent. This means that in the US, a credit card is about 2.3 times more expensive than a home loan on an average.

In comparison, in India, a credit card (at an average interest rate of 34 per cent) is about 3.2 times more expensive than a home loan (at an average rate of 10.5 per cent). What this comparison does not reveal, however, is that the lowest interest rate in the US on a credit card is around 7.50 per cent per annum which is not that far off from the home loan rate.

Why credit cards burn a hole in your pocket

In India, however, the lowest credit card interest rate is around 20 per cent, which is still twice the home loan interest rate.

There are various reasons for this anomaly.

1. The Indian rates are completely distorted by a 12.24 per cent service tax on the interest charged on a credit card, which is not charged (mercifully so) on the interest payable on any other kind of loan.

So, clearly a part of this problem is due to government taxes and the card issuing banks cannot be blamed for this.

2. Banks in India tend to charge the same rate for all credit card customers, irrespective of their credit profiles and payment history. Rate differentiation depending on past credit and payment history is just beginning to make its presence felt in India and this situation will correct itself to some extent in the future.

Why credit cards burn a hole in your pocket

3. The biggest reason for the higher rates, of course, is the relative price inelasticity of borrowings through a credit card. Simply put, it means that the kind of consumers who use a credit card to borrow from their banks care more about the convenience that is offered on a credit card and they either are blissfully ignorant of the actual interest rates charged to them or prefer to ignore the interest rate, hoping to pay off the borrowing quickly.

Since the actual amounts of borrowing on a credit card is normally small (around Rs 25,000 to Rs 50,000) the total interest charged even at the stiff rates of 34 per cent per annum works out to between Rs 800 to Rs 1,500 per month.

As the absolute amount looks small, the lay consumer rarely bothers about calculating the actual interest rate.

4. A very interesting fact is that if the consumer spends Rs 50,000 on a credit card and only pays off the minimum amount of 5 per cent due every month, then at an interest rate of 34 per cent per annum it will take him about 11 years to completely pay off the amount with the total interest payable at Rs 57,000 during those 11 years being far in excess of the borrowed amount of Rs 50,000.

Why credit cards burn a hole in your pocket

So, what are the lessons for a regular consumer from this?

First, a credit card is a very useful instrument as a means of payment. But it should be used as a borrowing tool very sparingly and if so, for as short a time as possible.

In fact, if you are unable to repay the total amount due on your credit card, then you can consider taking a personal loan (which is much cheaper) to pay off your dues. Of course, if you are going to use the limit on the credit card all over again, then you are much better off not taking the personal loan.

Moral of the story: Use your credit card responsibly -- don't overspend and if you do somehow end up overspending, have a concrete plan to repay as quickly as possible.