Author- Zain Altaf
Introduction
Credit card as the name suggests is a credit facility. In earlier times, the purpose of credit card was not the same as what we have today. Earlier, the cards were issued by companies to help bill their clients on purchases done from their own companies or stores.
Currently, credit cards are better known as credit facilities provided by banks and other financial institutions. It is considered a short-term and high-risk facility that yields higher interest rates than other products.
Are you a credit card holder and eager to use your new and flashy credit card? OR do you aspire to get one?
Wait! Be aware.
In this article, we try to educate people without financial background on the complexity behind the usage of credit cards. It is not an in-depth analysis, as we have just chosen a few important points that may help to educate the readers.
The concepts that will be discussed are widely used but may differ based on countries and financial institutions. This article does not intend to undermine the impact credit facilities have on peoples’ lives and economics; it is just an effort to create awareness among people so they can choose wisely.
Who decides on the credit facility, what assessment is done and how much credit do I get?
Depending on the regulations imposed by the governing authorities and internal risk appetite of the financial institutions, a person’s credit history and net worth is assessed before deciding on the limit of the credit facility that is to be given.
Financial institutions have separate departments with specialists who approve or reject customers’ credit applications.
A credit specialist digs deep into your current and past credit facilities. They asses your debt burden ratio (DBR) which is the ratio or percentage of liabilities or commitments an individual or company has against their income. Other important things that they consider is source and frequency of your income, payment history of past and current credit facilities, available assets, social and demographic status, and other internal assessments.
Example: Assuming Mr. Andrew is a vehicle salesperson working with the local car dealership and he is applying for a credit card from his local financial institution and the regulatory authority of a country has set debt burden ratio (DBR) at 50% of the income (INC).
If his monthly income (INC) is $10,000 and he has an existing home loan with a monthly installment (MI) of $3,000 and other credit facilities of monthly installments (MI) of $1,000 then his total debt burden (DBR) currently stands at $4,000 which is at 40% of his income ($4,000 (MI) ÷ $10,000 (INC) X 100 = 40%).
As we have assumed that the bank cannot provide a facility exceeding the debt burden ratio of 50% which in this case would be $5,000 (INC X 50%). The bank is left with an opportunity to provide facility to the person not exceeding $1,000 {$5,000 (permitted DBR) – $4,000 (existing MI)}.
In order to ensure that the bank does not give a facility where monthly installments will result in the persons debt burden ratio to increase by more than 50% of the income, they will have to set a credit facility not exceeding $1,000.
Continuing with our example, now we must determine as to how much facility can a person get to not to exceed the $1,000 mark.
The calculation is made considering the minimum payment that the financial institution requires against the credit card. Minimum payment is what the banks expects the customers to pay against the amount customer has charged to their card which is provided in the monthly statement. In this case we will assume that the bank expects a minimum payment of 5% of the statement amount.
So, in order to determine the credit amount for the customer, the specialized department needs to look into the facility amount in which the minimum payment of the monthly statement should not go above $1,000.
Thus, the banks decide on a credit facility of $20,000 as 5% of this amount will be $1,000 which does not exceed the DBR.
While the above example helps us to determine the credit facility based on finances, the financial institutions have a lot of data which they use to determine risks. So, it may happen that Mr. Andrews while being financially fit to avail a credit facility may have his application rejected based on other factors such as bad payment history for older or current credit facilities, his employer having a history of layoffs or he is working in a sector that is in a high-risk business.
What is in it for the financial institutions and how do they make money?
Credit card is a highly profitable product and since it is an unsecured facility, the financial institutions are at liberty to charge higher interest rates and charges in a smaller period.
Below are the few kinds of interest and charges that the facility holders can expect:
Annual Fee (AF) –This is a fee that is levied on customers based on the service and price guide of the financial institutions. It is not necessary that the financial institution charges this amount but it is a good question to ask before requesting for a credit card facility. In order to compete with other financial institutions, they may offer some perk against the annual fee that they charge.
Interest Rate (IR) – The financial institutions charge a fixed or percentage-based fee on the outstanding balance of the statement; these charges are generated every month and are levied on the carry forward outstanding of the previous statement. However, one must note that in many cases the interest rates are calculated from the date of transaction and many financial institutions consider a credit card month not by using the Gregorian calendar, but they may consider 25 days as a month. This is important to know so a person can understand how to calculate the billing and the due date.
Please note that the banks may have variety of interest rates based on the kind of transactions. For example: The retail purchases made through the credit card may have a lesser interest rate as compared to a cash withdrawal made from the credit card. Some banks also offer loan on card where they may charge an interest rate higher than the personal loan but less than the credit card interest rate.
Late Payment Charges (LPC) – In case the customer is not able to complete the minimum payment within the prescribed due date, the customer will be charged an additional fee apart from the interest rate. These fees can be fixed, or percentage based. The customer should note that EVEN if a partial amount from the minimum payment is due, they will be charged the late payment fees. In some cases, the financial institutions may also choose to charge its customer every fortnight or any other frequency. While these charges may seem unnecessary, the financial institutions are permitted to charge for late payment based on an understanding that they face an opportunity lost when customer do not pay them on time and having the late payment charge in place helps financial institution to persuade its customers to pay on time.
Over Limit Charges (OLC) –This charge is a surprise for many customers as they don’t realize that they can go over the limit even though their facility has a limit assigned to it. This normally happens when a customer has utilized his or her credit limit and is later charged with IR or LPC which resulted in the outstanding balance going over and above the credit limit. These charges are normally charged as a fixed fee. It is to be noted that there could be rare acceptable reasons for going over limit like delayed posting of transactions, and few banks also allow a certain percentage above the limit facility.
In a few countries, the financial institutions are not allowed to charge over limit fee if you have not given a consent to process payments that go over and above the credit limit.
However, many a times consumers are not aware that they have given their consent thus it is always advisable to discuss with your credit facility provider if this service is active and if it can be deactivated.
Cash withdrawal charges (CWC) –In case the customer chooses to withdraw cash from the credit card, they may be charged with a one-time fee for withdrawing the cash. This charge is additional to the interest rate that institutions may charge based on the cash transactions.
Consumers are advised to check with their bank on the interest rate and charges that are levied for withdrawing cash through the credit card as generally these charges are greater than the retail purchases.
International transaction fee (ITF) –Many consumers are unaware that financial institutions may charge an additional fixed or percentage-based fee on a transaction made internationally. This fee may be charged on top of a lower conversion rate as compared to the market rate.
While using your credit card, you may have the option to pay in your home currency. Sometimes, it is better to pay in a foreign currency and let your bank convert it to your local currency, as the POS provider may provide a rate for your home currency that may not be to your advantage. It is always best to compare your bank’s charges before travelling so an informed decision can be made.
Cheque returns fee (CRF) – Some customers may choose to pay their credit card bills through cheque payments. If the cheque is returned the bank may charge the customer a fee.
Statement fee (SF) – In case the customer requests the financial institution to provide a duplicate statement or a physical statement through mail then the banks may charge the customer a fee to provide the service.
Installment plan fee (IPF) – If the bank has a provision of installment plan and a customer requests for it then the bank may charge them with a one-time processing fee over and above the interest rate that they would have made for the installment plan.
Credit Shield / Insurance (CS) – Many financial institutions provide this facility through third parties whereby they may collect from the customer and transfer to the facility providers. Most of the time these fees are optional. However, lack of awareness leads to the consumers enrolling for these facilities without having the intention to be in it.
These fees are not necessarily discouraged and it can be a good protection tool. However, like any other insurance facility, the consumers are advised to read through the terms and conditions to understand if this facility is really for them.
There could be instances where the customers are automatically enrolled for the facility. Upon receiving their statements, they may contact the bank and discuss the opportunity of cancelling the facility if they do not find it appropriate for themselves.
Depending on the provider, the coverage can include permanent or temporary disability, involuntary loss of employment, and critical illness.
As mentioned earlier, we advise customers to ensure that they read the terms and condition as the coverage comes with conditions like claim intimation period, percentage of disability, length of service before involuntary loss of employment, critical illness being a pre-existing condition before enrolling for credit shield and many more.
Apart from above, there are many other fees and charges which can differ between financial institutions regionally. Normally they are informed to the customers when receiving their credit card or are available on request.
Credit card in Islamic banking
As Muslims are not permitted to deal with interest, there is a rise in demand for Islamic banking. Concept of Islamic trading is used to provide Islamic financial services and the products are not limited to Muslims only.
Most of the products are based on physical goods, fixed charge and ethical billing which makes it an attractive business opportunity for many financial institutions and financial product consumers. In fact, internationally well-known banks like HSBC, CITI Bank & Deutsche Bank are already offering Islamic products.
Unlike conventional card, there is no concept of interest rate in Islamic banking thus there are other alternatives for making money like fixed fee service.
In a fixed fee service, the consumer pays the bank a fee irrespective of how much of the credit facility they utilize.
This can be a very good product for consumers who have a rotating balance on their credit card. Since the fee remains the same and to compete with other conventional and non-conventional banks, the Islamic banks must keep the fee at a competitive rate.
Due to the fierce competition in the financial market, a few Islamic banks have come up with a concept of ‘Hadiya’ meaning gift. So, if a customer has not utilized any amount on the card the bank still charges the fixed fee but as a gift reverses the amount.
Islamic bank cards do come with some limitation as they cannot indulge into unethical billing and trading. Therefore, the cards may not function with merchants that provide sale of alcohol, pornography, gambling etc.
Loyalty & perks: Are they free?
There are a lot of marketing campaigns where financial institutions try to provide perks in order to compete with their counterparts.
Haven’t we all been in a conversation where people talk about the benefits they receive from the credit cards they own.
How about the call you get from your bank offering you an amazing interest rate if you transfer your balance from other financial institution to their credit card?
Have you wondered why financial institutions do that?
Just like any other market, there is a fierce competition in the field of financial services. Thus, in order to win over new clients, the financial institutions offer loyalty points and perks.
While loyalty points and perks are not a disadvantage, a person really needs to understand if these loyalty points or perks are worth their money.
A few financial institutions may also provide extraordinary facilities against the credit card like free pass to certain events, premium airport lounge access, loyalty points against usage that can be converted into affiliate program points, elite club memberships, converting purchases from selected outlets into less or 0% interest installment plans or discounts offers.
While all of these are advantages, consumers need to understand that nothing comes for free.
In order to get these benefits, you will need to spend your money through credit card thus assuming you will be using the money you do not possess at that moment. While an informed person would use the facility for loyalty points and perks only and will settle the amount before interest is levied, there are many people who are unable to do the same thus the interest and charges they accrue may be greater than the savings that they would have gotten while availing the loyalty points or perks.
Therefore, consumers must ask themselves if they can manage to use the facilities minimally and not get themselves in overspending situation which would lead to additional costs in terms of interests and charges.
What happens if you are unable to pay?
In a situation where an individual is unable to pay a credit card debt, the financial institutions will take measures which can be extreme in some cases.
Most financial institutions either have an internal collection team or have outsourced the process to third parties. The aim of these units is to minimize the bad debts and collect as much as money possible from the delinquent customers.
In order to perform their job, they break the moral code at times and are always persistent.
Every country has their own laws pertaining to the collection activity performed by these financial institutions. It has been noted that in a few countries consumer can go to jail for not paying the due amounts. In other countries the laws are very stringent with the way collection activity is performed, it is always best to speak to a lawyer or a specialist to understand your rights.
Most of the countries now have their internal credit reporting systems. All financial institutions are required to report the consumers’ financial details to the credit reporting authorities which after providing a calculation, they will assign a score.
The credit score is used by other financial institutions to determine the risk associated with their customer. A person who is delinquent with many financial institutions may not be able to avail any new credit facility
The score can also have an impact on other facilities like telecommunication products, housing and business credit.
There have been cases where uninformed consumers indulged into credit facilities and were left delinquent. After a few years, once they were mature and wise about their financials, decide to settle their past debt but had to pay a lot of interest and charges to settle them.
As we explained earlier there are late payment, over limit charges and interest rates that are levied on the facilities thus leading the amount to be much higher than the actual usage of the facility.
Additional examples for better understanding
While we have explained many features of the credit card, we would like to continue with the example of Mr. Andrew to provide better understanding of different concepts that we have discussed.
Example – 1: Mr. Andrew availed his credit card with a limit of $20,000 in the month of Jan 2018 and the financial institution has set his statement date to be on 10th of every month with an interest rate of 3%.
So, before 10th of Jan 2018 Mr. Andrew had spent $5,000 on his credit card and since there was no carry forward balance, the institution sent him a statement with $5,000 and minimum payment of 5% that would be $1,000 with a due date of 5th of Feb 2018.
Assuming Mr. Andrew paid the $5,000 before 5th of Feb 2018, he will not be charged with any interest. This is the best-case scenario.
Example – 2: Assuming Mr. Andrew paid only $2,000, then the statement will be generated on 10th of Feb 2018 with an outstanding balance of $3,090 (carry forward of $3,000 + 3% interest = $90) and a minimum payment of $154.50 (5% of the statement balance) to be paid before due date 7th of March 2018. Please note that the interest amount is for indicative purpose only. In reality, the interest will be calculated from the date of usage on a pro rata basis which cannot be easily computed manually.
Did you notice that the due date has been changed to 7th of March 2018? This is due to the fact that credit card due date is 25 days after the statement is generated and since march is a smaller month the due date has been extended to cover the 25 days period.
Example – 3: In continuation of Example 2, let’s assume Mr. Andrew paid the complete amount of $3,090 before 7th of March 2018 and reuses his credit card on 8th of March 2018 for an amount of $19,000.
In this case, his next statement will generate on 10th of March 2018 with an outstanding balance of $19,000 and minimum payment of $570 (3% of statement amount) to be paid by 4th of April 2018. However, the interest will be NIL since Mr. Andrew had cleared the outstanding balance before the due date.
Example – 4: Continuing with our 3rd example, lets assume that Mr. Andrew did not pay any amount then the financial institution will be charging Mr. Andrew with the interest and late payment fees. Let’s assume that as per the institutions service and price guide the late payment fee is $200.
$19,000 (statement balance) + $200 (late payment charges) = $19,200
$19,200 (statement balance) x 3% (interest percentage) = $576 (interest amount)
$19,200 (statement balance) + $576 (interest amount) = $19,776 (Current outstanding balance)
Did you notice that the credit card outstanding has crossed the assigned limit? Now due to being over limit there is an additional fee and assuming that as per the institutions service and price guide the over limit fee is at $200.
Thus, outstanding balance will be $19,776 + $200 (over limit fee) = $19,976
Mr. Andrews next statement which generates on 10th of April 18 will be of $19,976 with a minimum due of $1,398.80 [$998.80 (the minimum payment at 5%) +$200 (late payment) + $200 (over limit)] payable on or before 5th of May 2018.
Please note that any additional charge is normally added to the minimum due thus the institution expects you to pay the charges on an immediate basis.
So, based on above the total interest and charges generated for the month of April 2018 is $999.28 [$599.28 (3% interest amount) +$200 (late payment) + $200 (over limit)].
$599.28 is 3% of the usage of $19,976 and as time passes by, the interest and charges will continue to accumulate.
So, against a lending of $19,000 the financial institution has already billed the customer an amount of $999.28 which is approximately a $5.25% return in such a short period. If the customer is unable to settle the card balance then the interest keeps accruing thus making it an excellent investment opportunity for the financial institutions because interest earned through other financial products are far less.
Psychological Impact
It has been noted that many individuals prefer using their credit card instead of cash as it creates a sense of money being saved. This is one of the biggest concerns as consumers end up with mounting debts just because the feeling of spending with credit card is not the same as the money being spent from their savings.
There is also an issue of minimum payment where consumers while using the credit facility just calculate the minimum amount that they have to pay to the bank but what they do not realize is that the minimum amount barely covers the interest thus paying the minimum amount just keeps you in the safe zone but costs you a lot in the long term.
When individuals face tough trials of mounting debt, it creates a negative impact on their personal lives and their relationship with others. The whole process of financial institutions trying to recover their money and limited resources of consumers’ earning the money can be psychologically disturbing.
There have been cases reported where individuals have resorted to suicide because of the mounting debt and the stress and anxiety associated with it.
Debt can also lead to depression which can lead or make worse other existing medical conditions such as heart diseases, diabetes, arthritis, asthma, cancer, obesity and many more.
I fell for it: what are my options?
As we are all aware that financial situations in a person’s life can vary and many people fall into financial hardships when they meet with issues such as critical illness, loss of business, loss of job etc.
Wrong choices made during the uninformed days can have a lasting affect even through the more matured part of our lives, but it is not all lost.
If you have fallen into financial hardships and are unable to pay your debt, there may be a few options to consider.
Try consulting financial advisors or debt counsellors. They are professionals who have knowledge and experience to deal with such situations and may be able to offer solutions that may help you to overcome your debt.
Speak to your financial institution and try and see if they can understand your situation and provide you with a solution. They do not want defaulting customers and while they may have stringent policies, they might have some temporary or permanent solution like fix monthly settlement plan at reduced or NIL interest rate, short settlement option where bank may offer you a discount on your current outstanding if you are able to settle with a one-time payment by borrowing money or selling your assets.
Lawyers can also be helpful, especially if you are being threatened with legal action. Depending on your region, the lawyer may also be able to help you with bankruptcy options.
Understand your rights, in pursuit of recovering money, debt collectors may be using illegal methods or may be using a gray area. You may be able to report them to the concerned authorities if you are able to understand your rights.
Is credit card a demon?
It depends. If consumers understand that it is a short-term loan and use it to settle the outstanding balance urgently, then it is a great tool to have.
If people intend to use the facility as a long-term loan, it is not a viable option.
Many people have come up with different ways to use the facility and not pay interest or fall into the debt trap. However, please note that each country and financial institutions have their processes related to any financial product.
This article is a general overview of how credit cards work. Readers are advised to gain proper knowledge of any financial products before availing themselves of the facilities and understanding the regional laws surrounding them.
Disclaimer: The above-mentioned article provides general information based on personal knowledge. Depending on jurisdiction and institution there could be differences. Readers are advised to use this article for information purposes only and to do their research before using a financial risk product. The article is not intended to defame any person, business, or state or to negate its importance.
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