We are hurtling towards the summer season, a time when people start to plan their expenses for travel, shopping and leisure. Those who won’t use disposable income to cover these costs might rely on the credit and debit cards in their wallets, giving them a choice between a short-term loan from the credit-card company, a bank account overdraft or a personal loan. But making the wrong choice when spending on larger purchases of goods or services can prove to be a very costly error.
Firstly, making the wrong decision about which kind of borrowing to opt for could make it more costly than it needs to be. The money one spends should go into purchases rather than going to a lender.
In general, overdraft costs of any kind are on the rise globally with banks curbing personal lending due to stricter credit requirements and tighter risk management. The times of credit-card companies chasing customers with low-interest rates on outstanding balances and banks having reasonable interest rates on overdrafts are long gone. Especially in the West, but increasingly in the Middle East, including the UAE, the costs for borrowing money for personal expenses are heading upwards.
“The use of credit and debit cards is quite widespread in the UAE due to many highly affluent spenders,” says Rudi Schneider, an Austrian financial consultant and wealth manager based in Ras Al Khaimah. “However, as everywhere, there are hidden costs in spending by plastic and these are rather high in the UAE as compared to western countries. I always tell my clients that they need to manage their finances and do their math.”
However, comparing interest or profit rates on cards is not the only thing one needs to consider. The time factor is also a fundamental aspect. Some credit cards offer attractive interest-free periods together with other bonuses. In the UAE, the interest-free period of most credit cards issued by the banks can be as long as 55 days.
While for many the interest-free period on a credit-card payment sounds interesting, it has to be taken into account that this period is covered by the merchant who pays the credit card company — and sometimes flow back to the consumer.
As a travel agent in Abu Dhabi who asked for anonymity tells GN Focus: “As a merchant it always amuses me how people often don’t know or forget that in order for someone to enjoy no charges or interest for 55 days we have to pay commission to the credit-card company at an average rate of about 2 per cent per month, which is basically the equivalent of 24 per cent a year.
“In other words, the merchant pays for a client’s free interest, which more than likely is built into the cost of the goods or services in any event,” he adds.
Interest, profit rates and the widely different spending patterns of the UAE population are complex. Pros and cons of credit cards, overdrafts and personal loans for a single purchase can be illustrated in examples as follows.
Let’s assume a UAE resident with an average salaried white-collar job at Dh12,000 a month wants to spend two weeks in this summer at a cooler place with his wife and two children and decides to book a club holiday somewhere at the Mediterranean Sea coast. Overall costs including flights and four-star accommodation would be Dh30,000.
Should you take a small loan or put a big-ticket holiday on your credit card? With numerous factors to consider, such as interest, profit rates and the different spending patterns of the UAE population, we take a look at the real cost of a holiday in the example here.
Let’s assume a UAE resident with an average salaried white-collar job at Dh12,000 a month wants to take a family vacation in the Mediterranean with his wife and two children. Total costs, including flights and four-star accommodation, would be Dh30,000.
Option 1: Book it on a credit card
Our holidaymaker decides to pay the travel agency by credit card. His agreed limit on the card is exactly Dh30,000 and the interest-free period is two months. He is able to pay back Dh4,000 per month from his salary, and interest will be credited monthly on a 365/30 basis to the loan amount. While this scenario sounds feasible to quickly settle the travel bill, there is one major drawback to it: the average annual interest rate charged on credit cards issued in the UAE is 37.75 per cent, a recent comparison has shown.
Thus, the scenario will be as follows:
Pay back schedule:
Month 1: Pay back Dh4,000, remainder Dh26,000 no interest
Month 2: Pay back Dh4,000, remainder Dh22,000 no interest
Month 3: Pay back Dh4,000, accumulated interest Dh682, remainder Dh18,682
Month 4: Pay back Dh4,000, accumulated interest Dh579, remainder Dh15,261
Month 5: Pay back Dh4,000, accumulated interest Dh473, remainder Dh11,734
Month 6: Pay back Dh4,000, accumulated interest Dh364, remainder Dh8,098
Month 7: Pay back Dh4,000, accumulated interest Dh251, remainder Dh4,349
Month 8: Pay back Dh4,000, accumulated interest Dh135, remainder Dh484
Month 9: Pay back Dh499, accumulated interest Dh15, remainder Dh0.
Altogether, our holidaymaker pays Dh32,499 over nine months for his family vacation. This is a financing rate of 8.33 per cent.
Pros: Money is quickly and conveniently available. The overall interest burden of 8.33 per cent does not look exaggerated when the expenditure is repaid according to a regular schedule.
Cons: The credit card must not be used over the repayment period for other expenses to avoid obligations over the monthly instalment of Dh4,000. It is also important to check if the receiving merchant charges fees on the credit-card transaction, which could blow up the overall payment amount significantly.
Option 2: Take a bank overdraft
Our holidaymaker decides to pay for the vacation with his debit card. He has an overdraft limit of Dh30,000 on his current account with a starting balance of Dh4,000. From his Dh12,000 salary, monthly expenses are Dh8,000, so he can leave Dh4,000 in the account as repayment every month. The interest rate for unsecured overdrafts on current accounts in the UAE stands at 20 per cent annually on average. Adding to this, some banks charge fees on overdraft facilities when the minimum account balance falls under a certain threshold.
Pay back schedule:
Payment of Dh30,000 from the current account with a balance of Dh4,000 is -Dh26,000
Month 1: Pay back from salary Dh4,000, accumulated interest Dh427, balance -Dh22,427
Month 2: Pay back from salary Dh4,000, accumulated interest Dh368, balance -Dh18,795
Month 3: Pay back from salary Dh4,000, accumulated interest Dh309, balance -Dh15,104
Month 4: Pay back from salary Dh4,000, accumulated interest Dh248, balance -Dh11,352
Month 5: Pay back from salary Dh4,000, accumulated interest Dh187, balance -Dh7,539
Month 6: Pay back from salary Dh4,000, accumulated interest Dh124, balance -Dh3,663
Month 7: Pay back from salary Dh3,723, accumulated interest Dh60, balance Dh0
Overdraft and minimum account balance fees paid separately: Dh500
In this scenario, our holidaymaker pays Dh32,223 including the starting balance, which is a financing rate of 7.74 per cent.
Pros: Convenient payment method, automatic reduction of loan amount through salary transfer. It’s easy to step up repayments or make extra payments without early repayment fees if additional funds become available.
Cons: The current account remains in overdraft status for eight months. If emergency cash is needed, funds might not be available. This also requires extremely high fiscal discipline.
Option 3: Take a personal loan
Our holidaymaker decides not to touch his credit card or his current account for an overdraft and instead asks the bank for a personal loan for expatriates with interest charged on a reducing balance. He manages to secure an interest rate of 6.5 per cent annually. The loan comes with a processing fee of 1 per cent of the loan amount and a credit life insurance that costs 1.25 per cent of the loan amount.
Pay back schedule:
Dh30,675 including fees and insurance
Month 1: Pay back Dh4,000, accumulated interest Dh164, remainder Dh26,839
Month 2: Pay back Dh4,000, accumulated interest Dh143, remainder Dh22,982
Month 3: Pay back Dh4,000, accumulated interest Dh123, remainder Dh19,105
Month 4: Pay back Dh4,000, accumulated interest Dh102, remainder Dh15,207
Month 5: Pay back Dh4,000, accumulated interest Dh81, remainder Dh11,288
Month 6: Pay back Dh4,000, accumulated interest Dh60, remainder Dh7,348
Month 7: Pay back Dh4,000, accumulated interest Dh39, remainder Dh3,387
Month 8: Pay back Dh3,390, accumulated interest Dh3, remainder Dh0.
Under this strategy, our holidaymaker pays Dh31,390 including fees and insurance, which is a financing rate of 4.6 per cent for the holiday expenses.
Pros: Cheapest method to finance larger personal expenses as compared to card and overdrafts.
Cons: The client needs a proper credit history and early repayments come with additional fees. “Obviously, a personal loan is the most viable option for one-time personal expenses,” Benjamin Tan, Customer Relations Manager at Citibank’s International Private Bank, tells GN Focus. “However, there is paperwork and some processing time necessary to obtain a loan, and this is why some people rather opt to whip out their credit or debit card to get things done. It all depends on the affluence of the individual customer and his financial literacy,” he says.