Pros and cons of buying on credit

RBI (India’s central bank) has recently hiked its repo rate to 7.5 per cent, which has had a cascading effect on interest rates on all retail loans. With loans getting dearer, it makes no sense to purchase household goodies on credit.

With interest rates on loans continuously on the climb and showing no signs of stabilizing, buying favorite gizmo or piece of furniture on loan can land up burning a hole in the buyer’s pocket. Let’s understand the rationale behind rate hikes and then examine the pros and cons of buying goods outright and via a loan.

Hike in repo rate, CRR responsible for interest rate increase In its third quarter review of the annual credit and monetary policy 2006-07, the Reserve Bank of India (RBI) has hiked its repo rate (the interest rate at which commercial banks borrow funds from the central bank) by 25 basis points, to make it 7.5 per cent.

Besides, just days after the announcement of the repo rate hike, the RBI, with a view to contain inflation and to curb excess liquidity in the banking system, proposed a phased increase in the Cash Reserve Ratio (CRR) of commercial banks by 0.50 per cent. Changes in these core bank rates have a direct impact on retail lending rates.

Not only that, the central bank has raised the provisioning norms for standard assets to 2 per cent from the existing 1 per cent. This means, for every Rs 100 disbursed towards loans on such assets, banks will have to set aside Rs 2.

All these factors put together have led to costlier loans. As far as personal loans and credit cards are concerned, the interest rates have leaped by almost 2-3 per cent.

With credit no longer coming cheap, if you plan to replace the furniture at your house or wish to purchase an expensive electronic appliance, what would you do? Would it be wiser to pay cash, make payment by credit card or take a personal loan? Examining each option let us find out what’s the most feasible one.

Buying upfront:

When it comes to buying household durables and appliances, it is an expense that is incurred and not an asset built over time. Taking a loan to fund such purchases can be termed as ‘consumption debt’, since such items are meant for regular usage and also depreciate over time. Therefore, the ideal choice would be to pay outright rather than going the loan route.

However, depending upon the type of and value of purchase, one can ascertain whether to pay for it outright or avail of credit. If it’s a small ticket purchase that the buyer wants to make, such as buying a new cell phone or an iPod, it will be better utilizing own money instead of tapping bank loans either by way of financing or credit card. However, if the desired goodies come at a steep price, such as furniture, a holiday abroad, etc., and one does not have adequate funds at immediate disposal, then the convenience of a loan or credit card can be availed.

Credit card payment:

Essentially, credit cards were introduced with the intention of meeting immediate cash requirements and avoiding tedious Cash transactions. However, spending on credit cards has undergone a paradigm shift. Credit cards are being swiped left, right and centre, to buy branded apparel, Ornaments, fancy gizmos and lots more, in spite of the fact that this mode of payment attracts a steep interest rate of 33 to 40 per cent per annum. Besides, if the credit card holder does not diligently pay entire card dues and merely settle the ‘minimum amount due’ on the card every month then he will land up bearing hefty interest costs, in addition to late payment charges and other penalties.

On the other hand, a credit card payment would make sense if the buyer gets a decent bargain/discount on the product or service he is paying for via a card. It also makes sense to use a credit card if the buyer receives add-on benefits such as a cash back offer, greater ‘interest free period for settling dues, zero interest EMI on card purchases, etc.

Taking a personal loan:

Currently one can avail of a personal loan for amounts ranging from Rs 50,000 to Rs 15 lakh, wherein interest rates range between 13 to 23 per cent. For household goods, borrowing is a ‘fifty-fifty’ call. A loan for big ticket purchases can be justified for the items that the buyer intends to keep for a longer time period, such as 8-10 years or more. Moreover, durables that have a significant re-sale value can be bought home on a loan.
Even before evaluating options one have while making purchases, the biggest factor to keep in mind are “needs” as against “wants”. “Needs” are essential whereas “wants” are show offs or can be done away with. At the end of the day, individual’s spending habits and the kind of discipline he imbibes, will entirely dictate how he can make the best use of credit.