Use credit cards as convenient means to pay, not as instruments to borrow

Credit cards: Avoid the minimum amount repayment trap

Almost all leading retailers — both online and physical stores — have tied up with a credit card issuer to offer lucrative deals. Many consumers have got credit cards only to leverage upon such discounts. Credit cards also provide the perfect marriage of convenience (make big purchases without carrying huge wads of cash) and instant gratification (buy now, pay later). However, you could get caught in a debt trap if you are not careful.

A debt trap is like getting caught in quicksand — you keep sinking because its difficult to get out. As debt piles up, your credit score falls. This, in turn, deprives you of other lines of credit. According to experts, defaults on credit cards are already on the rise. “We have seen distress cases rise twofold in the past few months, since the economic slowdown. Most of these are young card users, and also those who have lost their jobs,” says Arun Ramamurthy, director at Credit Sudhaar. The younger card users stack up debt faster due to lack of financial literacy, limited savings, and lower income. According to the RBI, the credit card outstanding in August was up 24.4 per cent, compared to last year. Between April and August, the credit card outstanding has risen 10.6 per cent. Similar growth has been observed in the unsecured personal loans segment.

The most common reason for the build-up in credit is that borrowers make a partial payment, which means paying only the minimum due. The balance, subsequently, gets added to the following month's bill. The combined amount attracts higher interest of over 3 per cent a month. Although paying the minimum amount helps avoid late payments and prevents adverse impact on one’s credit score, the cardholder ends up paying hefty interest on the accumulated amount.

If you have an outstanding of, say, Rs 2 lakh and pay only the minimum amount due, it would take you a minimum of 57 months to bring down the outstanding to Rs 2,000, if the issuer charges 3 per cent interest each month (see table).  You will end up paying above 50 per cent of the outstanding amount as interest. Even if you clear 75 per cent of the outstanding every month, it will still take you five months to bring down the outstanding to Rs 2,000.

If you have a significant credit card outstanding, there are a few ways to bring it down to avoid a debt trap. However, it requires discipline and cutting down on discretionary spending. If you have multiple credit cards, you may transfer the balance from the card that charges higher interest to the one that charges lower interest. You could also take recourse to a personal loan to clear the debt on your credit card. The interest rates on personal loans are lower than those on credit cards. Another option is to convert your credit card dues into EMIs.

A credit card should be treated as a convenient means to pay, and not as an efficient way to borrow. “Ensure that your spending is in line with your repayment capacity and is not based on your projected income. Spend within your income and pay your bills on time and fully. In addition, use your debit card more so that you only spend the money that you have in your account,” says Mrin Agarwal, founder and director of Finsafe India.