Free Press Journal

Credit Cards: What you need to know

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Having a credit card is not a new thing; they have been in existence for several decades now. But even today, many are sceptical of being sucked into the world of ‘living on credit’. In a three-part series, Nikunj Gandhi will be demystifying myths and bringing to the fore some facts associated with being a credit card holder

They say, if something has a price tag, it can be bought. And in order for the statement to hold true, the good lord invented the visa power. So it sure is a big thing when the bomb drops with the golden words “you’ve been pre-approved” and be issued with your first credit card from your primary bank. It does tickle one pink to think that you are credit-worthy enough to be entrusted with this honour of being given credit without the jeopardy of defaulting.

Disclaimers


These are based on some assumptions:

Credit cards work on the primary principles of lending, that is, banks lend money to those who don’t need it. So if you are that desperate gambler who has accumulated some debts with some very dangerous people or if you think that your next 4D TV shall come out of your credit card, forget it, you’ll only be sucked into the debt contagion. It’s only helpful if you have the purchasing power and are liquid enough to actually afford the same.

The credit cards can act as a double-edged sword and works on the principles of the power of compounding. If you find yourself on the wrong side of the power of compounding of money, then it shall work against you and you shall experience an unnecessary erosion of your capital in the form of penalties, interest payments and even interest on interest payments.

The credit cards are to be used taking ‘time value of money’ into consideration. To simplify, a rupee today is worth lesser tomorrow. So, if someone offers you an interest-free grace period to defer your payments to future, a rational argument would be to take it. That money can be invested elsewhere today to buy income-generating assets.

Credit cards enhance your purchasing power and are not an alternative to your incomes. Your spendings should be commensurate to your incomes, irrespective of the credit limits the bank decides to offer you.

The idea is to use the credit card judiciously only as a means of convenience and not utilise any facilities which would enable the banks to earn incomes from you.

There is always a possibility that the card may be lost, you may be mugged, or it could be misused online. Whatever the eventuality, it’s always judicious to tread with caution and have a backup plan in case of any unforeseen circumstances.

Workings of a credit card company

A credit card service is primarily provided by a banking institution upon a close scrutiny of your creditworthiness. I really wouldn’t like to go into the nuts and bolts as to how incomes are generated by the banks by providing this service, but I’d rather dwell on the logic as to what are the incentives for the parties involved in a credit card transaction.

Broadly, there are three prime parties involved in any transaction….you, the merchant establishment from whom you buy goods and services from, and the bank. The merchant enters into an arrangement with your bank whereby the bank agrees to pay on your behalf to the merchant and then charges you for the outstanding amount on the settlement date.

Merchants’ incentives

The merchant is ensured of timely payment and does not have to bother about a default risk no matter how shabbily you are dressed to buy a Rolex. You flaunt the visa and you are ensured of the possession of goods. The merchant also has the incentive to make volume sales as credit cards are a widely accepted payment option and he may lose out on a sale if he is unable to provide a visa facility or insist on a cash transaction.

Banks’ incentives

The banks enjoy a discount on the list price that the merchant offers to you, upon repayments made by the banks to the merchants. So for example, you buy a good whose list price is Rs 100…the merchant swipes an equivalent amount on your credit card. However, he may receive only Rs 96 from the bank; the discount that he has to provide to the bank for facilitating this sale. The bank then bills you for the entire Rs 100 at the end of the credit period.

The banks argue on the fact that because they help the merchants generate a volume trade, they should have the power to avail a discount on the list price while making payments to those merchants on your behalf. Of course, this is after the bank works on the cost-benefit analysis for the trade-off between the discount it enjoys from the merchant and the interest-free credit period they provide you with. Only when the benefits are skewed in favour of the banks, will they agree to provide you with such benefits in the first place!

The banks also have an incentive to earn interest income from you, in case of a default. They also have the power to inundate you with a slurry of finance charges upon using their various facilities that I’ve listed.

Nikunj Gandhi is an Equity Investor and can be reached at nikunjgandhi@hotmail.com. These are his opinions and not necessarily of the newspaper’s.