Why Is Credit Card Debt Considered a 'Bad Loan'

Jan 17, 2024 / Reading Time: Approx. 6 mins

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Why Is Credit Card Debt Considered a 'Bad Loan'

In recent years, credit cards have emerged as a popular and convenient means of payment, embraced by millions for their versatility in facilitating everyday transactions. With their enticing benefits, such as rewards points, cashback incentives, the provision of credit card loans, and the instant accessibility of EMI facilities, these plastic companions offer a plethora of financial conveniences.

However, a potential financial pitfall lies beneath the alluring surface of these plastic cards. Despite their benefits, credit cards can damage your financial well-being when used recklessly.

This article delves into the complexities of credit card debt and explores why it is widely considered a 'bad loan,' shedding light on the intricate dynamics that can either make them a boon or a bane. Understanding the nuances of credit card debt is crucial for individuals seeking to navigate the fine line between financial convenience and potential pitfalls.

Before we move any further, let's first understand the meaning of 'good debt' and 'bad debt'.

What Is a 'Good Debt' and a 'Bad Debt'?

Debt has become an integral part of our lives, and taking specific loans is often unavoidable when aspiring to achieve certain goals early on. Loans like home loans and education loans are generally considered 'good loans' or 'good debts' as they actively help in managing financial requirements crucial for milestones such as home ownership or funding a child's education. Conversely, 'bad loans' or 'bad debts' are associated with personal loans, instant app loans, and excessive reliance on credit cards, potentially burdening individuals with a debt load that proves challenging to repay.

Distinguishing between a good debt and a bad debt involves assessing their impact on shaping one's financial future and evaluating the value they provide in relation to the cost of a loan.

For instance, an education loan secures a promising future, and a mortgage loan proves beneficial as the property's value appreciates over time. On the contrary, bad loans can jeopardise financial well-being, offering little to no value in return. An example would be a personal loan for a vacation, which increases monthly EMI obligations without contributing to long-term benefits.

Therefore, the nature of the purchase made with the loan determines its classification as good or bad. Nevertheless, perceptions of good or bad debts may vary among individuals. For instance, for someone involved in the transportation business or needing a daily commute vehicle, a car loan may be viewed as a good debt. However, if an individual opts for an extravagant car beyond their budget, leading to depreciating value and burdensome EMIs, that same car loan transforms into a bad debt for that person.

What Is a Credit Card Debt and Why Is It Considered a 'Bad Debt'?

The temptation of immediate access to funds and increased purchasing power often tempt many cardholders to shop beyond their budget and needs. Reckless use of credit cards has the potential to accumulate a substantial debt that may become challenging to settle before the designated due date. Furthermore, most credit card providers offer loans against credit cards, presenting another alluring option for cardholders to get instant money, which adds to their existing credit card debt.

While a particular loan could be termed good or bad depending on the purpose of the loan, most individuals, including financial experts, consider credit card loans as bad debt. Here's why:

1. Credit Card Loans Are High Interest Rate Loans:

Credit card debt is usually the costliest form of debt one can avail of. The interest rates, also known as Annual Percentage Rate (APR), attached to credit cards typically exceed 12% p.a. and, in some cases, reach up to 42% p.a. -even for individuals with favourable credit histories.

In contrast, optimal interest rates for education loans, home loans, and other secured loans often fall well below 12% p.a. Hence, it is generally advised against using credit cards for significant expenditures such as medical expenses or paying children's tuition fees if alternative options exist, as there are likely more economical alternatives available.

2. 'EMI Payment Option' Is a Trap:

The 'EMI Payment Option' can be a deceptive trap associated with credit cards. This feature allows cardholders to make purchases from specific merchants using an EMI facility or convert their big-ticket purchases into loans.

Cardholders typically opt for these options without scrutinising the Annual Percentage Rate (APR), which typically ranges from 12% to 42% per annum or even higher, coupled with a processing fee that can go up to 1% to 3% of the outstanding amount. In instances where individuals are experiencing financial constraints, they may choose to convert their purchases into EMI facilities without realising the prolonged financial burden that can last for years.

3. Paying the 'Minimum Amount Due' Is a Big Mistake:

Settling the complete balance before the due date offers the benefit of an interest-free credit window that spans up to two months. Conversely, merely paying the minimum amount due deprives you of any interest-free credit period.

By clearing the entire outstanding balance on your credit card, your bank extends an interest-free credit period. In contrast, limiting your payments to the minimum dues subjects you to additional interest charges on the outstanding balance, accruing from the time of the initial purchase.

The more substantial the outstanding debt, the higher the interest rate you will incur. Over time, these interest rates tend to rise as the bank assesses your repayment habits and perceives higher risk, subsequently charging you higher interest rates. Remember, often paying only the 'Minimum Amount Due' increases your chances of falling into a debt trap.

4. The Loan Amount Does Not Add Any Value:

As discussed earlier, good loans are generally secured loans like home loans and loans against properties. It is a general belief that assets appreciate over time, and the value of your secured asset, for example, a house, will increase in the future. Similarly, taking an education loan for a professional course will increase your chances of landing a high-paying job.

Top of Form

Credit card debt is typically incurred for purchases that do not appreciate over time. It is often used for items that depreciate, such as home appliances, clothing, footwear, gadgets, and consumables like food, drinks, diesel, and petrol. While there's nothing inherently wrong with these purchases, paying interest on them is unnecessary and can significantly inflate their actual costs.

Here Are Some Tips to Use Your Credit Card(s) Wisely:

1. Limit yourself to two or three credit cards and refrain from getting additional ones, resisting the allure of signing up for more.

2. Adhere to a meticulously crafted monthly budget, ensuring your spending aligns with your financial capacity. Avoid surpassing your income and set aside savings.

3. Commit to paying the entire balance in full and on time each month.

4. Resist the urge to raise your card limit.

5. Avoid relying on the card for essential expenses; opt for cash, especially if uncertain about promptly settling recent purchases.

6. Exercise caution with big-ticket purchases, taking a week to assess necessity and compatibility with your budget before committing to such expenses.

To conclude:

The use of credit cards can be a double-edged sword. While they offer convenience and potential rewards, the pitfalls of accumulating credit card debt loom large. It is crucial to recognise that credit cards become problematic when balances are not paid off in a timely manner.

Understanding the intricacies of credit card dynamics and avoiding the accumulation of debt is paramount. Credit card debt is considered a 'bad debt' due to its high interest rates and lack of association with appreciating assets.

So, while credit cards can be harnessed for rewards and benefits, the key lies in diligent financial management. Use credit cards carefully, seizing the perks they offer, but always prioritise paying off the balance in full each month to sidestep the pitfalls associated with falling into a credit card debt.

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KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.

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