Credit card and effective interest rate

Suppose you own a credit card that charges an interest rate of 3.1% per month for revolving credit. What would be the yearly interest rate you end up paying the bank that have issued you the credit card? Is it 3.1 x 12 = 37.2%? Well, no!

Let’s see why.
Consider that you have made a purchase of Rs. 50,000 in your credit card having 3.1% monthly interest and have paid only 20,000 on the due date. The bank will take forward the remaining amount (30,000) to the next month's bill with an interest charge of Rs. 930 (3.1% of 30,000), making the total amount due to be Rs. 30,930.

Now suppose once again you couldn’t pay the entire amount and you paid only 20,000 out of the total due amount of 30,930. The bank will charge an interest of 3.1% on the remaining 10,930 (not 10,000). Thus the bank charges interest on the previous interest amount also or simply, the interest charged is compounded! Due to compounding, the effective annual interest rate will be higher than 3.1% x 12.

The effective annual interest rate, when monthly interest rate is quoted can be found out using the following method.

Effective annual rate = (1 + i/m)^m – 1
where i is the nominal yearly interest rate (3.1% x 12 = 37.2%) and m is the total number of compounding periods in a year (12, since monthly).

Effective annual rate = (1 + 0.372/12)^12 – 1 and that comes out to be 44.25% instead of 37.2%!

Think about a lender who charges 44.25% for the money that you borrow from him. That’s exactly the reason why we should keep our credit card spending to the minimum with absolutely no revolving credit.

Base year and number of commodities used for inflation calculation in India

By this year end, the government will adopt a revised Wholesale Price Index (WPI), besides considering actual prices from next month.

Instead of the current 435 commodities, the revised WPI will have 980 commodities included in it, which will be rationalized by incorporating new items, removing unimportant items and amalgamating similar items.

The base year will also be revised to 2004-05 from the current base year of 1993-94. Thus the new WPI would give a more accurate figure for inflation. More news here.

So finally, the government is doing something on various debates happened over inflation calculation in India.

Related Articles
- How is WPI inflation rate calculated in India?
- Commodities and their weight-ages in WPI calculation of India
- Inflation rates of India (2009)
- Inflation rates of India (2008)
- The magic of Inflation

Poll Result: Will India attain double digit growth rate?

Will India attain double digit growth rate?

From rags to riches

A crorepati who lives in a hut!

The awe-inspiring story of a first generation entrepreneur! Sarath opens up his mind about the hardships he faced while making his company a success. I particularly liked the following statement he makes.

Quoting Sarath,
We talk about India shining and India growing, but we should ensure that people do not die of hunger. We can be a developed country but we should not leave the poor people behind. I am worried for them because I know what hunger is... Thoughts that are quite in line with the article by Pankaj Mishra about which I wrote in this post.

Sarath is a classmate of mine from IIMA's MBA programs. I hope that his story will be an inspiration for each and every one of us to start something similar and take India to one of the topmost countries in the world.

Effects of CRR hike on Inflation seen through money multiplying effect

The Reserve Bank of India, on 29th April 2008, increased the Cash Reserve Ratio (CRR) by 25 basis points (0.25%) to 8.25% as a policy measure to curb inflation in the country.

Cash Reserve Ratio sets the minimum reserve money banks must hold to deposits they own. A CRR of 8.25% means banks have to keep 8.25% of the total deposits they have with them as a cash reserve and shall not lend it to others or use it for any other purposes. In earlier periods this reserve was meant to protect depositor money in case a bank went bankrupt. But nowadays CRR is used as an effective tool in monetary policy to control interest rates and borrowing and is also used by developing countries like India and China to control inflation.

One of the main reasons of inflation is the money supply in the economy. When people have more money in their hands, they tend to pay more for goods and services (Supply vs. Demand) thereby increasing their prices. When CRR is increased, banks will have to keep more money as reserve restricting them to lend that much money into the economy. A CRR hike of 0.25% means Rs. 9000 Crore of extra money has to be kept as reserves, which means that that much money will be taken out from circulating in the economy and from being avaiable in the hands of people for spending. As a result people tend to pay less, making prices of goods and services (or inflation) come down.

This has more implications than what it appears prima facie. Money usually has a multiplier effect. Suppose a bank has Rs. 100 in deposits, with a CRR of 8.25%, it has to keep Rs. 8.25 with them and remaining Rs. 91.75 they can lend to borrowers. The borrower then gives the money to someone (through payment or lending) and the person who receives it (or if the person who receives it gives it to someone else and so on, then the last person who receives it) would deposit it in another bank. The second bank will keep 8.25% of the deposit of Rs. 91.75 and lend Rs. 84.18 to some other borrower. And the cycle continues.

In this way money available with a bank will in turn be available for various other banks for lending, due to the multiplier effect of money described above. Hence money taken away from the banking system through CRR hike will have a much higher effect, as the percolation will cause multiple increase in the overall cash reserve.

Thus higher reserve requirement results in reduced money creation in the economy and is accentuated by the multiplying effect of money. Hence increasing CRR is a highly effective method to reduce money supply in the economy; there by reducing inflation.

Personal Loans and debt traps

I get marketing calls from various banks each day which informs me that due to my good credit history with the bank I become eligible for a preapproved Personal Loan for my disposal and is available at the nod of my head. Already bearing the burden of a Personal Loan, I know for sure that it’s the last thing I shall go for and I reply them that I am not interested.

Personal Loans are collateral free loans given out by banks. It’s an unsecured loan and hence banks charge exorbitant interest rates for it. Since the money borrowed using Personal Loans is less compared to other loans, the EMIs appear lesser (else banks will make the tenure higher and make it appear less) and hence people generally don’t think much about the total money they pay to the bank through EMIs over the tenure. There are few things one should know about Personal Loan and these are also the reasons why Personal Loan shall be the last thing one shall resort to while in need of cash.

1. The interest rates banks charge is typically in the range of 20%! Just think about a Gold Loan where the interest rate is around 7%

2. Most Personal Loans come with an initial processing fee of around 2%. Consider a Personal Loan of 1 Lakh, where the processing fee itself will take 2000 bucks off you

3. Banks charge a pre-payment penalty when the Personal Loan is closed before its tenure, which again take money out of you

Thus, despite having a very high interest rate, even more money is extorted by Personal Loans making it one of the costliest of all the loans and thus a debt trap. Hence go for Personal Loans only if there are no other options in front of you.

Of Micro SIPs

For mutual funds having a Systematic Investment Plan (SIP) option, the SIP amount came down to as low as Rs. 500 per month but there were a lot of people out there for whom it was still unaffordable; people who are engaged in daily wage jobs, small businesses etc. and wanted to benefit from the higher returns of equity market.

From April 2007, few fund houses have allowed people to invest in SIPs with money as low as Rs. 50 per month. This could benefit about 330 million paid workers of India who didn’t have access to such investment schemes earlier.

But there are certain things that could affect the popularity of micro SIPs. PAN card being made mandatory for mutual fund investments by SEBI, distributors not pushing micro SIP due to lower commissions involved, longer SIP terms of around 60 months are few of them. But looking at the revenues that micro SIPs could rake in for Asset Management Companies due to its scale, let’s hope that this shall become a success, increasing the savings power of the average Indian and also making our equities market much bigger and stronger than they are now.