Case 012Lending and leverageWarm up

A client carries Rs 4 lakh on a credit card at 42% a year while holding a Rs 6 lakh fixed deposit at 7%. What does keeping both cost him a year, and what would you have him do?

The situation

Kiran Pawaskar, 31, has a Rs 6,00,000 fixed deposit earning 7% a year, which he thinks of as his safety net. He also carries a revolving balance of Rs 4,00,000 on his credit card, built up over a family medical bill and a move, and pays a little more than the minimum each month. The card charges 3.5% a month, 42% a year.

He pays tax at an illustrative 20% on the deposit interest. Breaking part of the deposit early would cost him an illustrative penalty of about 1% on the amount withdrawn. Kiran says he would rather not touch the deposit, because it makes him feel secure.

Your task

What is the yearly cost of holding both, and how do you make the case to Kiran without dismissing his wish for security?

Quick check

What does Kiran lose each year by keeping Rs 4 lakh in the deposit instead of clearing the card?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Keeping both costs Kiran at least Rs 1,45,600 a year. Rs 4 lakh on the card costs Rs 1,68,000 at 42%, while the same Rs 4 lakh in the deposit earns Rs 22,400 after tax. Break Rs 4 lakh of the deposit, pay an illustrative Rs 4,000 penalty, and clear the card. He keeps Rs 2 lakh in the deposit, and the freed card limit is a backstop.

Step 1Why do the card and the deposit not cancel out?

Picture filling a bucket from a tap while it leaks through a hole six times the size of the tap. The water level is not safe just because water is going in. A debt and a saving of the same size cancel on the balance sheet but not in cash flow, because they carry different rates. Kiran's Rs 4 lakh on the card costs 42%; his Rs 4 lakh in the deposit earns 7%, and the interest is taxed while the card interest is not deductible. Every year he holds both, he pays the difference.

The same Rs 4 lakh: what it costs on the card against what it earnsCard interest, 3.5% a monthRs 2,04,427 if compoundedCard interest, 42% simpleRs 1,68,000Deposit interest, 7%Rs 28,000Deposit interest after taxRs 22,400Keeping both costs at least Rs 1,45,600 a yearRs 1,68,000 paid, less Rs 22,400 earned after tax; about Rs 1,82,027 if card interest compounds
On the same Rs 4 lakh, the card costs Rs 1,68,000 a year at 42% while the deposit earns Rs 22,400 after tax, so holding both costs Kiran at least Rs 1,45,600 a year.
Step 2How big is the cost, done properly?

Simple interest first: Rs 4,00,000 at 42% is Rs 1,68,000 a year. The deposit earns Rs 28,000 on the same amount, Rs 22,400 after 20% tax. The net cost is Rs 1,45,600 a year, which is 36.4% of the Rs 4 lakh, simply for keeping money in the wrong place. If the balance were left unpaid, 3.5% a month compounds to about 51.1% a year, and the cost rises to about Rs 1,82,027. Card charges usually attract GST as well, which adds to it; confirm the current rate on the statement.

On Rs 4 lakh, per yearRs
Card interest at 42%(1,68,000)
Deposit interest at 7%28,000
Tax on deposit interest at 20%(5,600)
Net cost of holding both(1,45,600)
One-off penalty to break Rs 4 lakh of deposit(4,000)
Holding both costs Kiran Rs 1,45,600 a year, while breaking Rs 4 lakh of the deposit costs a one-off illustrative penalty of about Rs 4,000.
Step 3How do you respect his wish to feel secure?

Take the feeling seriously and show him where security actually comes from. A deposit that sits beside a 42% debt is not a safety net; it is a safety net with a hole in it. After clearing the card he still has Rs 2,00,000 in the deposit, and his full card limit becomes available again for a genuine emergency. There is a hidden cost too: while a balance revolves, most cards charge interest on new purchases from day one, so he has also lost the interest-free period on everything he buys.

Then close the loop so it does not happen again. Cancel any standing habit of paying only a little over the minimum, set the card to be paid in full by auto-debit, and rebuild the deposit from monthly savings. Say the limitation: if Kiran's income were unstable and the card might be cut, keeping more cash would have a stronger case. For a salaried 31-year-old, the arithmetic decides it.

Where candidates lose it

The usual miss is netting the two balances and calling his net position Rs 2 lakh of savings, as if that settled it. The question is about rates, and the answer is a yearly rupee cost.

The other is forgetting tax on the deposit interest, and the monthly compounding on the card, both of which make the true cost larger than the headline 35-point gap.

What the interviewer asks next

  • Kiran's deposit is locked for another two years with a heavier penalty. Does the answer change?
  • Would a personal loan at 14% to clear the card be a good middle path?
  • How would you set up his accounts so this does not recur?

Company names and figures are illustrative.