CREDIT CARD â€“ â€œTHE EXPENSIVEâ€?
Ever wondered why the average rate of interest on credit cards is around 34% per year, when the average rate on a home loan and personal loan is around 10% and 18% per annum respectively?
One reason is the higher risk of default that banks carry due to the completely unsecured nature of the credit card product.
For example, in the US, the average interest rate for a 30 year fixed rate home loan is around 6% whereas the average credit card interest rate is around 14%. 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 rate of 34%) is about 3.2 times more expensive than a home loan (at an average rate of 10.5%). Yet, the lowest interest rate in the US on a credit is around 7.5%, which is not that far removed from the home loan rate. In India, the lowest credit card rate is around 20%, which is still twice the home loan rate.
There are various reasons for this anomaly:
The Indian rates are distorted because of the 12.24% service tax on the interest charged on a credit card mercifully this is not charged on the interest payable on any other kind of loans.
Indian banks tend to charge the same rate for all credit card consumers irrespective of their credit profiles. However, this situation will correct itself to some extent in the future, as rate differentiation depending on payment history is now beginning to make its presence felt.
The biggest reason for the higher rates is the relative price inelasticity of borrowing through a credit card. The kind of consumers who use a credit card to borrow, care more about the convenience. They are either ignorant of the actual interest rates charged or prefer to ignore it, hoping to pay off the borrowing. Since the actual sums borrowed on a credit card are normally small (around Rs 25,000 to Rs 50,000), the total interest even at 34% per annum works out to Rs 800 â€“ Rs 1,500 per month. Since the absolute amount is small, consumers rarely bother about calculating the actual interest rate.
An interesting fact is that if you spend Rs 50,000 on a credit card and only pay off the minimum 5% due every month, then at 34% annual interest, it will take about 11years to completely pay off the amount!! And the total interest payable over those 11 years would be Rs 57,000.
A credit card is a useful instrument as a means of payment. But it should be used as a borrowing tool very sparingly and for as short a time as possible. In fact, if you are unable to repay the total amount due on your credit card, itâ€™s better to take a personal loan (which is much cheaper) to pay off the dues.