Credit Card Debt: How Does It Work and How to Deal With It

It is often said that nothing more can be added to the happiness of a man who is in health, has a clear conscience and is out of debt!

While health and conscience are relatively intangible constructs, debt is not. Especially the kind of debts that you make in good times but are compelled to retire in bad times.

Credit card debt is one among this kind which has a spiralling effect on the individual’s personal finances and consequently on the overall economy. Recently, SBI’s Credit card wing reported the rise in its Non-Performing Assets (NPAs) to 4.3% as of September 30th. Furthermore, a lofty 9% of its receivables of ₹24,000cr ($3.2bn) are currently under RBI’s resolution plan, indicating some level of adversity.

Although it is natural for customers to despair and default in the midst of an economic crisis, it is worthwhile to note that self-employed retail borrowers defaulted the most.

Quick Refresher on Credit Card Debt

Simply put, credit card debt is a form of unsecured liability that is incurred through revolving credit card loans. It is not collateralised and it carries some of the highest interest rates in the industry.

The outstanding balances on these cards keep accumulating month after month if they are not not repaid quickly. They are classified as what we call “revolving credit”, meaning that the debt recycles and reappears if not paid in full or above the agreed-upon threshold.

As per the RBI, there were 5.61 crore credit cards operational in the country as of January 2020.

Two obvious charms about credit card debts: ease of accessibility and option of deferred payments. Transaction within the credit limit can be done by customers on an as-needed basis. Conversely, if left unpaid for too long, they can lead to high outstanding balances, delinquent payments and negative impact on credit score.

How Do the Credit Card Deferred Payments Work?

At the core of this process is a tenure period called the credit cycle, which is one whole transactional (or billing) cycle done on the card. Most cards have an interest-free “grace period”, within which, debts if repaid in full don’t incur any interest.

If it’s not paid in full by the due date, banks charge a daily rate of interest on any outstanding credit balance on the card. Daily rate is calculated by dividing Annual Percentage Rate (APR) by 365.

Let’s say you pay ₹50,000 ($677) for a phone on the card on October. On 30th October, your credit cycle ends and the Payment Due Date is on November12th. Here, the grace period is 28 days (from the date of purchase). Any default beyond this date would incur a daily rate of (40%÷365) or 0.11% considering the interest rate is 40% (standard approximate rate).

A daily rate of 0.11% incurred on ₹50,000 could add up to ₹30,000 ($406) alone in interest costs (66%) in just a year (factoring in the additional 18% GST levy). There is also another component called “Minimum Due Amount” (AKA transactor credit), which is a nominal payment (usually within 10% of the total amount) which is a recompense amount mandated from the customer, if not the full amount. If he chooses not to pay that either, he will incur additional charges and more importantly face scrutiny by credit bureaus making it difficult to borrow in the future.

Macroeconomic Effects of Credit Card Debt

When the moratorium on term loans went into effect in March 2020, it cast a severe gloom over the banks and their ability to continue lending without the expectation of having those debts serviced for six months. This explains the proliferation of NPAs that accrued from the non-serviced loans turning bad without regulatory scrutiny over the last six months.

However, RBI data shows credit card debt shrinking by over a quarter for the first time in a decade during April-June 2020 period (as opposed to a 22.5% growth in FY20 and 28.6% in FY19). This reversal in credit behaviour can be explained due to a general downsize in expenditure during the pandemic and stall in purchasing ability during the lockdown.

Current outstanding credit card debt is poised to touch ₹1,10,000cr ($14.9bn) and banks stand to earn up to ₹10,000cr ($1.3bn) on accumulated interest charges (estimated for the first three-month moratorium) if all customers decided to rollover their repayments.

This figure is expected to rise for the extended six-month moratorium. However, the Government’s recent offer to waive off “interest on interest payments” is expected to cause a delay (if not a dent) in the banks’ earnings.

How To Manage Your Credit Card Debt?

One of the most effective ways to monitor credit card debt is to check one’s credit squander by turning the revolving and transactor credits into term loans. Repayments are scheduled and structured this way as monthly payable instalments. The rate of interest is also typically lower (10–15% versus up to 42% on credit cards in India) which won’t accumulate high.

“Debt Avalanche” and “Debt Snowball” are employable strategies in clearing credit card debt. The former involves paying off the debt with the highest interest first. The latter involves paying the smallest debt first and then gradually working your way up. Issue with both strategies is that they are fundamentally motivational and will cost you a lot of money and time.

Liquidation is often considered a last resort to make debt payments. If one were to compare interest received from investment against interest accrued through credit card debt, the latter is usually high enough to nullify the former and is thus easier to bargain off.

(Originally published October 26th 2020 in transfin.in)