Monthly Archives: May, 2007

Pay For Yourself Instead Of Paying To Credit Card Company!

One day, I received a call on my cell phone (unsolicited) and a sweet talking voice announced that it’s a call from Xyz Bank and that I am the lucky one selected from their database being eligible to receive a free life time credit card with a credit limit of 1 Lakh Rupees. Sweet talking voice also informed that I will be eligible to receive free accident insurance, club membership benefits, discount coupons, festival offers, cash back facility, blah blah blah.  Sweet talking voice asked for the confirmation when to send Bank’s executive to complete the paper work.    

I fixed up a time for that and started dreaming as to what are things I can do when I receive my credit card 

Ø       I can buy latest clothes, sports shoes, mobile phone etc.

Ø       I can also buy latest model of IPod, Digial camera, DVD player

Ø       I can go on a trip to Goa..Kumarakom..

Ø       I can take all my friends to that chic pub for my birthday party

The list continued to grow longer and longer till I fell asleep. 

Next day when I was about to start-off to office when I received a call from another sweet talking voice.  This time the voice announced that she has come know about my intention to apply for a credit card and a Certified Financial Planner would like to talk to me about an alternative plan.  She also informed that she will send a vehicle to pick me up from my workplace during the lunch break to meet up with CFP and discuss the alternate plan over lunch and that I will be dropped back to my office in time. I agreed for this meeting with CFP thanking my luck. 

I was promptly picked up that day afternoon and driven to a posh hotel. There was waiting for me at the lunch table a gentleman in a blue suit with a laptop kept ready on the table.  As soon as I sat down after thanking him for the kind offer, with a waive of hand he called a waiter and ordered for the lunch.  The next moment he started off with his presentation about an alternative plan to credit card – a  “Pay for myself” scheme. 

Without wasting much of your time, I give here the gist of the alternative proposal.  I still do not know how this CFP had all my personal information but here they are 

Credit limit available in Xyz Bank’s credit card – Rs.1 Lakh 

Amount I intend to use in the next 15 days through credit card – Rs.1 Lakh 

My monthly surplus after accounting all my expenses – Rs.6000/- 

Minimum amount I need to pay my credit card – Rs.5000/- 

When I will be fully repaying the credit card loan at this rate – nearly in 31 months 

Total Interest I would pay the credit card company – Rs.55,000/- Rate of interest – 36% Per annum

 The strange alternate plan CFP proposed was some what like this. 

Postpone my purchases till such time I have enough cash in my bank account (in any case you can live without them!) 

Save an amount of Rs.5000/- every month through an SIP in a mutual fund 

At an expected annual return of 12%, in roughly about 18 months I should have a sum of Rs.1 Lakh in my mutual fund account 

Spend the money as I like from the mutual fund account with the condition that I will repay the amount to my SIP account every month 

I may be eligible to get some cash discounts on my purchases

I suddenly stopped eating my lunch.  My blood boiling with cold rage, I started yelling at the CFP about his stupid idea of saving first and then spending my own money.  Why should I do it when I have the option to use Xyz Bank’s money and the easy option of paying in installments.  After paying part of the amount, I can use the balance credit limit again (my list was not fully exhausted when I spend lakh of rupee using my card) and I can keep paying the minimum amount to the credit card.  It’s cool using the plastic money!

The CFP interrupted in the middle and informed with a smile on his face that I will continue to work for the sake of credit card company and not for myself and If I continue to use my credit card in such a manner, all my surplus income will have to be given to the bank.  I really got wild with his utterance.  I picked up a glass of water on the table and threw the contents at CFP.  With annoyance I noticed the CFP suddenly vanished in to thin air and somehow all the water turned and fell on my face. 

I woke up suddenly from the sleep to realise that all this call from CFP and luncheon meeting was just a dream. I started off to my work with the happy feeling that I will be meeting the executive from Xyz bank to apply for a life time free credit card. 

If any of you meet any CFP any time, be forewarned.  They will ask you save your own money first and then spend.  They will also ask you to pay for yourself instead of paying to credit card company. 

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The “Top Up” trap

Akash works for an ITES company in Bangalore. He is young (24 years) and single (obviously, 24 years is the age at which life begins, marriage is not on the horizon).

Akash always loved cars as a kid. When he got his first job soon after he graduated, he wanted to fulfill his childhood dream. He purchased a used small-car that cost him Rs.1.5 Lakhs, a fortune considering his annual salary then was Rs.1.4 Lakhs. He borrowed Rs.50000/- from his Dad and took for a personal loan from his bank. Interest rate was 10% and the EMI was Rs.3227/- for a tenor of 3 years (36 months). Akash had no problem in getting the loan sanctioned quickly as his salary was getting credited to his account with the same bank. His dream fulfilled, Akash was a happy man driving around the town with his new acquisition. Akash repaid Dad’s money when he received his first year’s performance bonus. Dad never asked for repayment and he was not charging any interest also. But Akash would have none of it. Even before he repaid bank’s loan he paid back the money to his Dad. He wanted to show Dad that he is a grownup responsible man now!

Akash received his first promotion recently. His salary has gone up by a lakh of rupees. He is now a team lead heading a team of 20. During the recent Team Leads’ Conference, One of his friends suggested him to upgrade his car to a latest one costing a cool Rs.4 lakh. His friend also mentioned that he borrowed Rs.3 Lakhs from the bank he is paying an EMI of Rs.9680/- per annum. Akash did a quick calculation in his mind. His old car will fetch him in the vicinity of Rs.1 lakh. He is already paying an EMI of Rs.3227/-. If he borrows Rs.3 lakh as suggested by his friend, his net increase towards loan repayment would only be Rs.6453/-. He can easily manage this as his salary has gone up. Akash called his bank the next day to have another loan for Rs.3 Lakhs. Bank Manager informed Akash that his bank’s policy does not allow him to sanction new personal loan when the old one still going on. He suggested an alternative. To top up the existing loan for the amount needed by Akash at the same rate of interest but for a new term of 36 months. This meant, technically, that the bank will foreclose the old loan and give a new loan for Rs.3 Lakhs plus the principal amount outstanding of the old loan for a new term of 36 months. Akash had to agree for this as it’s convenient for him to take the loan from the same bank. Akash paid Rs.1000/- as one time foreclosure charges and was happy to get the new loan sanctioned over phone and the draft delivered to the car dealer very next day. Car dealer also arranged for a buyer to his old car and in a couple of days Akash drove the new car to office proudly. On the face of it, this appears a good deal for Akash. No hassles of additional paper work and every thing taken care over phone! He happily paid Rs.1000/- towards foreclosure as he wanted the new loan sanctioned quickly.
Everything seems alright on the face of it. But is it so? Let us analyse a little bit more in depth how equated monthly installment concept works. The mathematics of EMI makes all the installments to be same. This means the EMI has to have two parts, one towards payment of interest and another towards repayment of principal amount. If one pays only the interest (as in an overdraft account let’s say), the loan amount will never get repaid. Therefore, for the loan to be paid off as per the tenor, borrower has to pay some amount towards principal also. The mathematics of EMI works out this figure for you wherein upto half of the number installments the proportion of interest would be very high and then slowly the portion of principal repayment increases and nearing the end of loan term there is high portion of principal repayment and small amount towards interest. When Akash paid EMI for a year, most of that was accounted towards interest charges. When he topped up the loan, outstanding balance of the old loan was added to the new loan amount and new EMI was decided. This meant that he will again start paying the interest for the whole amount What if his bank had sanctioned him another personal loan with the old loan continued as it is?

Here are some figures for you.

Total interest Akash would have paid for the old loan – Rs.16162/-

Interest paid upto the time loan was topped up – Rs.8646/-

Total interest Akash would have paid for a new loan of Rs.3,00,000/- – Rs.48486/-

Total interest Akash would have paid for both old and new loans
(Rs.16162 + Rs.48486) = Rs.64648/-

Total interest Akash would pay for topped up loan – Rs.59787/-

Total interest Akash would pay for topped up loan and old loan – Rs.59787/- + Rs.8646/- = Rs.68433/-

Additional burden because of topping up = Additional interest of Rs.3785/- + Foreclosure charges Rs.1000/- = Rs.4785/-

In addition to foreclosure charges, Akash ended up paying interest again on the amount for which he had already paid the interest. The amount of Rs.3785/- seems small but if the calculation is done for let’s say topping up after 2 years and for a higher principal, the difference is even more.

Just because bank has a policy which does not allow the Manager to sanction new loan when the old one is outstanding, they use the trick of topping up the loan and the borrower ends up paying the interest all over again. Akash could have repaid the old loan fully (instead of repaying the amount to his Dad) and/or negotiated for a new loan. But then he was in a hurry and it cost him an additional sum of Rs.4785/- Lenders routinely call up their existing customers who are in the mid period of loan term and convince them to top up the loan with no additional paperwork. All transactions are done over phone and no questions asked about the end use of the money. People fall into this trap easily and end of up paying interest many more times.

Here are some suggestions:

• Do not top up the loan. Only the lender benefits in this arrangement. Borrower ends up paying foreclosure charges also.
• If you have to borrow additional sum, negotiate for a new loan. If this is not possible talk to another bank. Today with ECS debit facility, many banks agree to lend even if the salary is not credited in to the account with them.
• Be clear about the foreclosure charges. Negotiate with the bank either to reduce or fully waive off the same in view of continuing relationship.
• Prod the lender with many questions to find out the hidden costs and charges. After all it’s in your interest to do so because you pay the interest
• Repay the loan first for which interest is payable. That way you will reduce the total cost of borrowing.
• Lastly, why at all borrow when you can save and achieve your dreams? If you borrow, you are actually using up your future earnings.