Tuesday, July 23, 2013

Are you aware about interest rate charged by your credit card company?

It has been long since Sanjay and Sanjana saw each other.  Both were busy in their respective work life.  In addition to that Sanjay was also studying for his professional course, which made it very difficult for him to meet Sanjana.  However, today being his birthday, both of them decided to meet up for lunch and spend the day together.

Sanjana was already waiting at an Italian restaurant when Sanjay arrives in new clothes looking smart.  Sanjana was visibly happy to see him after a long time.  She hugged him and gave birthday wishes.

“Gorgeous birthday boy, thanks for meeting me on your birthday at least. Otherwise where do you find time nowadays to meet me?”  as usual Sanjana started teasing him.

“Come-on Sanjana, you know how much busy I am at work and studying for the exams due next month.  I hardly get time for any other activities.” Sanjay started justifying himself.

Sanjana asked looking at the menu, “So how are your studies going on for the exams?”

“Still only half way through.  I need to devote more time on the studies for the remaining part of the month.  And better I do, otherwise the examination fees shall go in the drain so the loan I have taken.”  Sanjay started cribbing.

Not understanding what Sanjay is saying, Sanjana asked “What’s the relation between your exam and loan?” ordering pastas for both of them.  As usual, she made a choice about what Sanjay should also eat!

“Listen”, Sanjay started explaining, “For the exams, I need to pay examination fees, which were quite substantial and to pay that I took a loan on my credit card.  So if I don’t do well in exams, my loan will go waste.”

Sanjana replied, “Well…irrespective of how much I educate you on money part, you still waste your money.  Taking a loan on your credit card!   How can you make such big mistake?  Are you aware how much this loan cost you?”

“You always take me for granted.  Of course I have learned about and implemented money management.  Moreover, I have taken care of it while taking this loan also.”  Sanjay started his firm defense.

“Is it?  Tell me what did you take care of while taking the loan?”

“First, as you had told me earlier, I made a list of various options I had to take a loan.  Then I compared their terms, interest rates and ease of getting the loan.  Based on these criteria, the loan on credit card was the cheapest and easily available.” replied Sanjay, visibly satisfied with his explanation.

Smelling something fishy, Sanjana questioned, “How did you conclude that the loan on credit card was the cheapest?”

“It’s very simple.  In fact, they are giving me interest free loan.  They are only charging me processing fee of 5% on the loan amount and that’s all.  I only need to repay the loan amount in equal installments over 6 month’s period.  Since there is no interest, it is the cheapest of all”, replied Sanjay brimming with smile.

Stunned by the reply given, Sanjana yelled, “Credit card companies lure you with interest free loans and you fall prey of such offers.  Where did your learning of time value of money go?  Did you compare how much you are paying to credit card company for the loan and at what point of time?”

Seeing Sanjay a bit confused, Sanjana continued, “Listen.  Let me explain to you.  This all is gimmick of time value of money.  They charge you ‘interest’ on the entire amount in the name of processing fee and term it as interest free loan.

“Assume that instead of processing fee, it is 5% interest on loan amount which needs to be paid once at the time of disbursement of loan.  What the credit card company has done is to charge interest on the entire tenure of loan even though you are not using the full loan for the entire tenure.”

“I am not getting this.” confused, Sanjay replied, “Give me an example.”

“Look.” Sanjana started explaining, “For example you took a loan of Rs. 50,000 from your credit card company repayable in 6 equal installments of Rs. 8,333.  Reducing processing fee of 5% from the principal amount, net amount you receive is Rs. 47,500.  This you repay @ Rs. 8,333 in six equal installments.  Simple IRR (internal rate of return) calculations on your excel spreadsheet shall tell you that you have paid yearly interest of more than 19% on this loan amount.

“This is so since you paid the charges on the entire amount and not on the outstanding amount post your installments every month.”

Visibly upset by being again cheated Sanjay said, “I never thought of processing fees as interest cost.  I got lure by the claim that the loan is interest free and there is only one time charge.  But as you explained, time value of money is of utmost importance which calculating interest cost.”

“Bang on.  Now you are on the correct path.  Compare what you are receiving and paying along with the time periods and calculate the cost.  It is very simple to determine by way of excel spreadsheet.  And you shall get the interest cost on the loan you have taken.”  Sanjana added and continued,


“Now, don’t get upset birthday boy.  Let’s celebrate your birthday today and take this lesson as a ‘valuable’ gift from me to you on your birthday.” winked Sanjana.

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