Last week my friend cribbed that her bank was not increasing her credit card limit. Another friend told me how he thought he had smartly chosen a floating rate home loan because it was cheaper, but found that the bank had hiked the EMI quite unexpectedly. I worry about the jargon in financial contracts and the difficulty that common people face in figuring them out fully. At the same time, I am also concerned about the attitudes that this lack of empowerment has created.
On one hand are those who believe financial contracts are frauds guised in legalese, and therefore view most deals with suspicion. On the other hand are those who are completely taken in by the packaging of a product and believe loans are acts of subservience to the ever-powerful consumer. The truth is, perhaps, in the middle.
The economics of a business is usually understood by asking how the benefits and risks are split between the buyer and the seller. A bank earns from the spread between the deposit rate and the loan rate.
If it expects the interest rates to move up, it will offer floating rate loans so that this spread is protected, even more so if the deposit is short-term and the loan is for a long period of time. It does not make sense to lock in a lower rate over a long time, and fund the loan with a short-term deposit whose rate increases from time to time.
If we lend to the banks we can celebrate the increase in rates, and if we are borrowers, rue the rate increases. Given that there are no free lunches in economics, we will end up paying or receiving market rates, and as long as banks compete for the same customer, these rates will not be too different.
Since most people go in for the lower rate, fixed or floating, banks have an incentive to keep floating rates lower, or stop offering a fixed rate altogether. So, when choosing a product, rather than asking how the rates will behave in future, customers should seek more information on the floating rate itself.
How does it change? With reference to which rate? How often? Who determines the market rate? Does the bank set the rate unilaterally? Since customers have not even begun to ask these questions, there are disparate practices in setting these rates.
Behind every transaction is a web of incentives. A bank will waive the annual fees on a credit card if it can earn more from the interest on the loans made through a credit card.
If more people buy the card because it is free, the amount of money due to the bank increases. Even if only a fraction of them roll over the credit, the bank will earn more from this than from the annual fee. What we need to understand is the payoff and who benefits from it.
If we need credit that can be rolled over several months and are willing to pay the interest rate for such a facility, then these factors should drive the decision to buy the card and not the waiver of annual fees alone.
The simple fact is that a credit card is a loan the bank makes out for an interest rate. Instead of informed borrowers giving banks incentives to reduce the interest rates, 'smart' borrowers pick up multiple cards, spend and default happily, and contribute to keeping the risks and the interest rates on credit card loans way too high.
If we choose to cut the hype, we can begin to see financial products clearly. The zero interest rate offer will then show up as collecting the interest in advance through a fee; the last-day incentive to sign up for a scheme will look like the 'last 2 days only' sale of cheap stuff; and those that push products knowing too little will be revealed as quacks dishing out miracle cures. Between bewilderment and skepticism is a nice space of empowered decision making, if only we choose.;
The author is Chief R&D officer, Optimix.
