You are shopping for clothes at a nearby mall. At the checkout counter, you have an option of taking a personal loan from an NBFC or swiping your credit card. You would most likely swipe your credit card. It is not about filling up a form for the loan and spending 10 minutes to close the process. It is just the nature of the expense. Paying for clothes. Just swipe the credit card.
On the other hand, if you were buying an expensive television and were offered the same 2 options, your choice may have been different.
While the merchant does not really bother how you pay (as long as you pay), you do.
Why Would You Prefer a Credit Card over a Personal Loan?
Credit card gives you an interest-free credit period. Not just that, you may get some discounts or earn cashback or reward points (which may have some monetary value).
Hence, if you can pay off the credit card bill in full by the next due date, credit card is certainly a good choice.
The problem is when you cannot pay your bill in full. Interest-free credit period goes away. And high interest cost makes cashbacks and rewards look meagre.
That’s where personal loans can come in handy. Personal loans allow you to spread payments over a period of time. You face lower cashflow pressure.
Hence, you must choose the credit instrument properly.
When you know upfront that you will struggle to pay a big expense by the next bill due date, it is not wise to use a credit card. It is better to take a personal loan in such cases. Alternatively, you can buy on merchant EMIs or convert the specific expense into a loan later (banks usually allow you to convert big ticket expenses to loans).
For me, the association between the nature of expense and the credit product is quite clear.
Credit card: regular consumption, utility payments, fuel, groceries, clothes, other shopping, small ticket expenses etc.
Personal loan: Vacation or experience, consumer durable, or an expensive gadget, any other big ticket expense that can affect my monthly investments (if paid through credit card).
What about Gold Loans?
Well, normally you would associate a gold loan with a medical emergency in the family or a business requirement.
Would you take a gold loan for say, buying a mobile phone or a television? Well, you might. Gold loan is likely to be cheaper than a personal loan too, but it is too much hassle for a small ticket loan. A personal loan is a more convenient option.
More importantly, at least with me, it is easier to mentally associate an expensive gadget purchase with a personal loan. Not with a gold loan or any other secured loan. I do not believe in optimizing things too much. It is OK to make slightly suboptimal (not foolish) choices if such decisions let you be at peace. No dissonance. Moreover, if the loan is short duration (that a consumer durable loan is likely to be), the rate of interest will anyways not make a huge difference in terms of overall outgo.
Loans for Regular Household Expenses
What if you take a gold loan to fund regular household expenses? Needless to say, the financial situation must be dire. Forget about the gold loan. If you must take any kind of loan to meet regular consumption, you have a big financial problem at hand.
Just by looking at the nature of expense and the choice of credit product, you can easily see that something is not right.
For such expenses, better use a credit card and pay your expenses in full. If you can’t do that, you need to address the issue at a different level. You must either increase your income or reduce your expenses.
What I have shared is nothing new. I am sure that you already have this kind of mental mapping. Such a mental mapping declutters your mind and simplifies decision making.
Note: I am not advocating that you use a credit card or take personal loans. I am just comparing different forms of credit. If you can fund these expenses directly from your bank account, nothing like it. However, in some cases, you may be better off using a credit instrument even when you have money in your bank account. For instance, you get 5% off on a purchase using a specific credit card and none when you pay directly from your bank account (using UPI/debit card/netbanking). You can pay using your credit card and then pay the card dues in full. Credit is a problem only in 3 cases
- When you cannot pay it back
- When the cost of credit is too high
- When you are irresponsible with credit and spend frivolously