Revolving credit

A credit card can be one of the cheapest ways to borrow in India, or the most expensive. The difference is entirely in what the cardholder does on the due date.

The workbook states the rule precisely: a credit card is an interest free borrowing option only if the use is within the limits specified and the repayments are made by the due date each month. At the end of the billing cycle, the total spent is the amount to be repaid, and paying it by the due date involves no charge.

When the user does not pay the entire amount — some amount is carried over for payment in the following business cycles — it is called revolving credit. From that moment the interest meter starts ticking, on an unsecured loan, at a very high rate. Given the exorbitant cost, the workbook's instruction is that revolving credit should be avoided.

The cost. If a card company charges 3% a month, the compounded annual cost is (1 + 3%)^12 − 1 = 42.6%. The workbook puts it in the same bracket as the unorganised sector — pawn traders and money lenders charging as high as 60–80% a year, or 5% a month.

Why it is so expensive. Credit card debt is unsecured — the lender has only the personal security of the borrower — so it is priced far above secured loans such as home, vehicle or gold loans.

Why people fall into it. Credit card debt is the most expensive way to borrow but also the easiest: swipe the card or enter the details online and the transaction is done. People spend more than they can repay immediately and get stuck in the revolving credit cycle, with dues growing quickly at the high rate. Payments by card also escape tracking — the workbook notes that eating out and entertainment spending often does not register with a client because it all went on the card.

The effect beyond interest. High utilisation of card limits and too much unsecured credit have a negative impact on the credit score.

The exits. Rank debt by cost and clear card dues first; refinance with cheaper debt — a credit card balance transfer is the workbook's example of refinancing; or use a loan against an asset, which is preferred over card outstanding where an asset is available, because the rates are lower.

Effective annual cost = (1 + monthly rate)^12 − 1
                      = (1.03)^12 − 1 = 42.6%

Illustrative figures, using the workbook's 3% a month.

Anand's card bill for the month is Rs 50,000. He pays Rs 20,000 by the due date and carries Rs 30,000.

Twelve months of carrying Rs 30,000 costs Rs 12,773 — 42.6% of the balance — and not a rupee of the Rs 30,000 has been repaid.

Compare the alternatives the workbook lists. Had Anand paid the full Rs 50,000 by the due date, the cost would have been nil: the card was an interest-free loan for the whole billing period. Had he instead raised Rs 30,000 through a loan against his mutual fund units at, say, 11% a year, the interest over a year would be about Rs 3,300 — roughly a quarter of the card's cost — because a secured loan is priced far lower.

The workbook's repayment-order example shows where such a balance sits: a credit card outstanding of Rs 30,000 at 42%, a personal loan of Rs 1.2 lakh at 21%, a car loan of Rs 1 lakh at 12% and a housing loan of Rs 15 lakh at 8%. The card is the smallest debt and the costliest by far, so every strategy clears it first.

Chapter 4 (Debt Management and Loans): section 4.3.2 (cost of debt) defines revolving credit and gives the 42.6% computation; 4.5 (responsible borrowing), 4.6 (secured and unsecured loans) and 4.8.6 (credit card debt) develop it; 4.15 uses a card balance in the repayment strategies. Expect the compounding calculation and the condition under which a card is interest-free.

• 3% a month is 42.6% a year compounded, not 36%.
• A card is interest free only on full payment by the due date, within the limits. Paying part of the bill is exactly what creates revolving credit.
• It is unsecured, which is why it is priced above home, vehicle and gold loans.
• A balance transfer is refinancing, not a debt waiver — the debt moves to a cheaper lender.
• High card utilisation hurts the credit score, separately from the interest cost.
• Loans against an asset are preferred over card outstanding where the borrower has an asset, because the rates are lower.