Emran wishes to buy her wife a gift on her first wedding anniversary and because of his tight liquidity condition is not able to plan a smart phone which his wife has craved for since its launch. Buying a cheaper phone and facing the repercussions of spending few nights on the bedroom balcony in cold autumn nights does not sound as a good option for Emran but at the same time he is helpless because of his tight liquidity state. He expects some heavy cash inflows in future and decides to go for a short term consumer loan from his bank and is ready to pay an additional interest over it but to his surprise and fortune he comes across a flashy ad on newspaper wherein the smartphone company is giving away phones on credit card EMI’s and that too without any interest. Without a second thought Emran goes to the vendor with his credit card; swipe, tap and whoosh- a new sparkling smartphone for his wife is in his hands.
In this kind of a 0% EMI credit card scheme a bank provides a consumer with financial assistance in such a way so that the bank pays the vendor of the consumer durable the entire value of the products purchased upfront and settles the balance with the consumer in equated monthly installments (EMI’s) without any interest. Apparently, to the naked eye, it seems that all the stakeholders in the transaction are contented i.e. the consumer and the vendor but why is bank so happy about the transaction which is lending a cost free loan funded by costly deposits. It is as good as doing charity. I remember in management classes I was being taught that every resource including the most liquid resource “money” comes at a cost. This business model of 0% credit card EMI schemes are rubbishing the “time value of money” concept on which the entire economic and financial theories rest. The accumulation of these contradicting financial equations in my mind forced me to dig a level deeper to understand the logic behind the cash inflows and outflows of this financial product. Let us again take a look at the transaction under financial microscope.
First, almost in all the 0% EMI credit card schemes a person has to pay a processing fees upfront ranging from 2-5% and this is a cost you wouldn’t have paid had you not opted for the zero percent EMI option. For a product costing 20,000 you have to pay an additional 1000 as processing fee in such a scheme which in other words mean that the bank has actually lend a loan of only 19,000 to you but your obligation is to pay 20,000 to the bank. This is costlier than interest in a way because the entire amount has to be paid in advance and does not amortize over the life of the loan like normal interest does.
Second, when you pay via the zero percent EMI option, you will not get any such discount as the offer is valid on total price. Even the freebies and accessories with products are trimmed down to compensate for the interest free credit. This again boils down to 3-5% loss.
Third, during this period, the credit limit on the credit card is blocked to the extent of the full transaction amount. It is released as and when the EMI is billed and paid for in subsequent months. So, a person has to remember that he will not be able to make any other purchases during this time. Also a bank is reducing its credit risk exposure and indirectly saving a capital charge on it.
Fourthly, using your credit card purchases for an interest-free period is fine; however, you must remember the bank can do away with interest-free periods or hike the interest rates according to its convenience. Any pre-closure of EMI attracts prepayment charges at the rate of 3 per cent on the outstanding principal amount. The bank reserves the right to revise the prepayment charges at its discretion, with prior notice, and such revised charges is binding on the borrower. Further, any delay in depositing the EMI will only worsen the debt as credit card debt is the costliest of all costing an annual rate of around 24% which coupled with compounding becomes hell of a spiral.
Keeping the malicious nature of credit card loans into consideration, RBI has recently issued a strong notice against use of such schemes by banks. Describing the zero per cent interest scheme as a ‘pernicious practice’ which deters customer protection and accounting integrity, RBI has said that banks should not resort to any practice that would distort the interest rate structure of a product as this ‘vitiates transparency in pricing mechanism’ and prevents customers from taking informed decisions.
Though the whole point of having a credit card is to provide customers with cashless convenience, it makes money-sense never to get tangled in the debt trap. An EMI purchase should never be used as the first option. It has definitely brought many things within the reach of the middle class. But it’s an option that must be exercised with great caution as it’s not as much of a free ride, though it may often appear as one.