CREDIT CARDS - AVOIDING THE DEBT TRAP

Case Story

Mr Michael Tan was a successful manager with an MNC drawing a monthly salary of $10,000. When Mr Tan was promoted in 1999, he upgraded to a bigger home and bought a new car. Mr Tan held credit cards with 8 banks, and spent more than $5,000 monthly on entertainment, fine dining and shopping. He did not keep track of his spending, and often rolled over his credit card payments. When the recession hit in 2002, Mr Tan's company downsized and he was retrenched. Although he was jobless, Mr Tan continued to chalk up debts on his credit cards and paid only the minimum sum every month. A year after losing his job, his savings ran out and he had difficulty servicing his credit card payments and other loans. Mr Tan's house and car were repossessed, and he was eventually forced to declare bankruptcy.

Spending on credit cards is not necessarily a bad thing. It only becomes a problem if you are not disciplined in controlling your spending, and allow the monthly bills to rollover and snowball. There were many things that Mr Tan could have done to avoid the situation he got himself into. Below are 3 simple but important tips on how to use your credit card responsibly and avoid the debt trap.

TIP 1 - Know the warning signs and implications of getting into too much debt.
Many debt cases like Mr Tan's can be avoided because there are tell-tale signs that you are getting into too much debt. People do not usually fall into debt traps overnight. It happens gradually. If you learn how to spot these tell-tale signs, you can do something about it. You should also know what the long-term implications are if you are unable to repay your debt.

Warning Signs:
1. You are in the habit of charging to your credit limit.
2. You do not keep track of how much you have spent on your credit card.
3. Most of your monthly income and/or savings go into servicing your credit card debts.
4. You borrow from your family and friends, or take cash advances to service your credit card debts.
5. You only have enough money to pay the minimum sum on your credit card bill every month.

Implications:
1. If you do not pay your debts on time or are unable to repay them at all, this will be reflected in your credit history. This will affect future loan applications even after you repay your debts.
2. Your creditors can force you into bankruptcy if you have debts of $10,000 or more. Bankruptcy will leave a black mark on your credit history and make it difficult for you to obtain loans in future. Bankrupts face additional restrictions such as not being able to travel freely or manage any form of business.

TIP 2 - Avoid the debt trap! Settle your outstanding balance in full every month.
You will not incur any interest charges if you pay the outstanding balance in your credit card in full every month. If you pay only the minimum sum (typically 3% - 5% of the outstanding balance or a certain dollar amount, for example, $50, whichever is higher) stated in your monthly statement, you will incur interest charges amounting to around 2% monthly or 24% per annum of the outstanding balance. This is the usual case unless your credit card charges a lower interest rate. Interest will typically be charged on the outstanding balance from the statement date and any new amounts charged to your credit card.

Assuming that you have an outstanding balance of $1,000 in your credit card statement carried over from the previous month and you only pay the minimum sum of 5%:
Minimum payment   = 0.05 X $1,000
                          = $50

If you do not incur other charges on your credit card during the month:
Estimated Interest charges = 0.02 X $1,000
                                     = $20
Repayment of debt  = $50 - $20
                           = $30
Thus, of the $50 paid, only $30 goes towards reducing the outstanding balance.
Remaining debt  = $1,000 - $30
                      = $970

Even if you do not chalk up any more spending on your credit card and you only service the minimum sum every month, it would take you more than 2 years to pay off your credit card debt of $1,000 and you would have incurred about $290 in interest charges in the process. If you had a bigger outstanding balance (for example, $10,000), you would need more than 8 years to pay off the debt and pay about $6,300 in interest charges. The interest charges actually take up a big percentage of your repayments. These hefty charges can be avoided if you pay the full amount on your credit card statement every month.

TIP 3 - Use your credit card responsibly
Credit cards provide convenience and are useful in times of emergency. But use your card responsibly and ensure that you pay your credit card bill in full every month. Remember that when you roll over your outstanding balance, you are getting a loan from the bank and that loan comes with an interest rate of 24% per annum, which is one of the most expensive forms of loans around.

Set a monthly budget for your credit card spending and keep track of your expenses. If having a credit card makes it hard for you to resist overspending, do not take up too many credit cards or use a debit card instead. With a debit card, you can only spend up to the amount you have in your account. By being disciplined in your credit card spending and using credit responsibly, you can avoid the debt trap.