friend posed an interesting question the other day.
She needed money and was wondering which avenue to explore.
This was her dilemma: should I incur the expense on my credit card and repay it slowly or should I take a personal loan?
Good question. What would you do?
Say you want to go on a holiday.
Would you foot all the travel expenses on your credit card and opt for revolving credit? What this means is, you pay only the minimum amount (5% of the total bill) or a little more and carry forward the rest to the next billing cycle.
Or would you take a personal loan and repay it every month in equated monthly instalments (fixed amounts paid every month comprising principal repayments and interest payments)?
Let's see the pros and cons.
i. In some cases, a card just cannot replace cash.
If you decide to use your card, make sure you have some cash to rely on.
Throwing a party? The caterer may insist on cash. You may want to buy loads of flowers. The florist will not accept a credit card; he too wants cash.
On both counts, the personal loan scores.
Let's say you are travelling. You can pay for the tickets and settle the hotel bill on your card. But what about eating in little joints that do not accept cards or shopping for knick-knacks in places where a card is not accepted? Or on taxis and other means of transport?
Cash in hand is definitely a necessity.
ii. You may get more with a personal loan.
Say you have a credit limit of Rs 30,000. You can only spend upto this amount on your card. But you might be entitled to a personal loan of Rs 50,000.
Your credit limit will drop further if you have not settled your earlier bill.
Let's say your credit limit is Rs 30,000 and you spend Rs 20,000. When the bill comes, you pay Rs 2,000 and carry forward Rs 18,000 to the next month.
You can now spend only Rs 12,000 on your credit card: Rs 30,000 (your limit) - Rs 18,000 (what you owe the bank).
Your spending ability will be limited until you repay what you owe on your card. Of course, if you revolve on your credit card, you will also have to pay interest.
iii. The credit card can get you in a soup.
Not to say the personal loan will not, but the chances of you getting into trouble with a card are higher.
Let me explain.
Going by the above example, if you owe the bank Rs 18,000, the bank will levy interest. After that, say you go and spend Rs 1,000 on a dinner. You are way within your limits; you do have Rs 12,000 at your disposal.
But this Rs 1,000 is now added to the amount you owe the bank (Rs 18,000) and interest is now charged on Rs 19,000. That sucks, right?
So, in such cases, the more you use your card, the more you end up paying.
iv. The card is convenient.
No documentation. No processing or administration fees. You did all that when you applied for the card. The hassles ended there.
You can get a loan within 72 hours, but you need to have all your documents ready.
You must also fulfill all the criteria required by the bank. The bank may not approve of the company you work for or may find you have not been employed for the minimum number of years required (five years in some cases).
v. The interest rate factor.
Ouch! This one really hurts!
On the face of it, a personal loan is cheaper than revolving credit. Just take a look at the interest rate. The interest rate on a personal loan hovers between 16% and 22%. It could go higher. And, in cases where banks are offering promotional schemes or lower interest rates for its customers, it could go lower.
Revolving credit is expensive: from 2.5% per month (30% per annum) to 2.95% per month (which works out to a phenomenal 35% per annum).
In sheer numbers, the personal loan scores.
But not always.
The trick is to figure out how the interest rate is calculated. Is it on a monthly or annual reducing basis?
Monthly reducing basis: When you make a payment every month, a small amount is deducted from the principal. So the following month's interest will be calculated on a slightly lesser amount. The result -- you end up paying less.
Annual reducing basis: The payment you make every year is deduced from the principal amount at the end of the year. So the following year's interest will be calculated on a lesser amount. You pay more than what you would have paid in monthly reducing.
Let's take an example.
Personal loan = Rs 20,000
Repayment period = 2 years
Interest rate = 22% per annum
EMI (the amount you pay every month when repaying your loan) = Rs 1,117
Let's say you revolve Rs 20,000 on your credit card for two years and the interest is 30% per annum. You will end up paying Rs 1,118 every month to the credit card company to clear this bill.
Why the difference of just Rs 1 per month for a 9% difference in the interest rate?
While the credit card interest was calculated was on a monthly reducing basis; the interest for the personal loan was calculated on an annual reducing basis.
Actually, interest on the credit card is calculated on a daily reducing basis. The moment you pay back an amount, the next day's the interest is levied on a lesser principal.
Do note, this example has not taken into account additional spending on the card. It assumes bill payments will be made every month.
So, which one?
In the final analysis, a personal loan is a safer bet than revolving credit.
- You will need a maintain lot more discipline if you are using a credit card. Restraint with plastic is extremely difficult. It is so tempting to fall back into the comfort of making the minimum payment on your Visa or MasterCard and revolving credit till the next due date! This could result in you paying the credit card company for a long, long time.
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Making fixed monthly payments on a loan is far better as there is a systematic, enforced payment pattern in place.
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Opt for a loan where the interest is calculated on a monthly reducing basis.
So, if you are looking at a quick fix option, no need to flip flop between the two. Choose the personal loan option. Keep your credit limit as a rain check for an emergency that requires instant cash power.
Illustration: Dominic Xavier
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