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Why are interest rates on credit cards so high

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MUMBAI: The interest rate on credit cards is much higher than on a personal loan despite both being unsecured products – there is no collateral. Adhil Shetty, CEO, Bankbazaar.com, explains the rationale for issuers charging interest rates as high as 42% on cards.

Credit cards are among the most popular and convenient forms of credit. Not only does a credit card makes it possible for you to access additional funds when required, but it also makes it rewarding to access credit.

Unsurprisingly, it is also one of the products that come with exhortations of responsible usage. The main reason behind this is the high-interest rates associated with credit cards.

Usually, credit cards have an annual percentage rate or APR anywhere between 21% to 42%. Compared to this, personal loans have an annual interest rate of 11-16%, making credit cards a much more expensive proposition. There are two reasons for this. The first is the way in which the product is structured, and the second is the unpredictability built around it.

To begin with, credit cards offer a revolving credit account that lets you repeatedly borrow money up to a set limit and pay it back over time. Unlike an instalment loan where you need to repay a fixed amount every month, revolving credit via credit cards give you the flexibility of choosing your repayment plan.

In most cases, there is no collateral or security associated with the credit card. This makes it an unsecured loan, and the inherent risk of default is much higher in this case. So, the high interest rates are compensation for the risk.

Second, the eligibility criteria for credit cards are lower than a typical personal loan. Coupled with this, users have all the power in terms of when and how to use their allotted credit. The issuer doesn’t know how often the card will be used, where the money will be spent, how much will be used or when it will be paid back. This unpredictability contributes to the risk involved.

The issuers alleviate the risk involved by way of a monthly billing cycle whereby the user has to pay a certain minimum amount every month. At the same time, the issuer charges a monthly interest on the unpaid amount instead of annual interest to restrict the period for which the funds will be rolled over. This makes the product more expensive.

Several issuers have been relooking the rate of interest associated with credit cards. Some of them have begun offering credit cards with APRs as low as 9% to select customers with high credit score and impeccable repayment history. The reasoning is that the risk in such cases would be much lower. So, in future, users with a good credit score and history can aspire to inexpensive credit cards.

(Do you have personal finance queries? Send them to [email protected] and get them answered by industry experts)

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