Credit card bill of ₹2 lakh vs personal loan of ₹5 lakh: The first conundrum of financial priority

When a person has a credit card bill of ₹2 lakh and a personal loan outstanding of ₹5 lakh simultaneously, at first glance the figure of ₹5 lakh seems huge and scary. The common mentality is that the debt which is bigger in amount should be eliminated first so that one can get mental peace. But under the rules of financial mathematics and personal finance, this can prove to be a huge and costly mistake.

From a purely financial and interest point of view, it is mandatory to pay off the credit card bill of ₹2 lakh first, while only regular EMIs of personal loan should be paid. The biggest reason behind this is the huge difference in interest rates between the two loans. Credit cards charge compound interest rates ranging from 36% to 48% per annum (about 3% to 4% per month), while personal loans typically offer simple annual rates of 12% to 16%.

Credit card debt is considered to be the most toxic debt in the financial world because the interest is calculated on a daily compounding basis and interest continues to be charged on the entire outstanding amount even after paying the Minimum Amount Due (MAD):

• Credit Card Bill: ₹2,00,000 (Average interest rate: 42% per annum or 3.5% per month)

• Annual interest burden only: ₹2,00,000 × 42% = ₹84,000 per year (i.e. around ₹7,000 per month only interest)

• Personal Loan: ₹5,00,000 (Average interest rate: 14% per annum, tenure of 3 years)

• Annual interest burden (initial year): About ₹60,000 to ₹65,000 per year (Monthly EMI around ₹17,089)

If you look closely, a credit card bill of ₹2 lakh eats up ₹20,000 to ₹24,000 more in interest every year than a personal loan of ₹5 lakh, even though the principal amount is less than half that. If you keep paying only 5% minimum amount due on credit cards, it will take 10 to 15 years to repay ₹2 lakh and you will lose more than ₹4 lakh in interest alone.

According to financial experts, there are two main scientific ways to get out of debt:

1. Debt Avalanche Method (Best Mathematical Strategy): In this, all the extra money is invested on the loan with the highest interest rate, while the minimum EMI of other loans is paid. Under this formula, preferring a credit card with 42% interest minimizes the total interest out of your pocket.

2. Debt Snowball Method (Psychological Strategy): In this, the smallest balance is eliminated first so that there is a feeling of mental victory. Fortunately, in this case the credit card (₹2 lakh) is smaller than the personal loan (₹5 lakh) and its interest rate is also higher. That is, according to both avalanche and snowball strategies, the credit card becomes the first target.

credit card balance directly to you Credit Utilization Ratio (CUR) From 80% to 100%. If your card limit is ₹2.5 lakh and you have spent ₹2 lakh, your CUR becomes 80% (whereas the safe limit is less than 30%). High utilization causes the CIBIL score to drop rapidly by 50 to 80 points.

In contrast, a personal loan is an ‘installment loan’ whose regular EMI payments help keep your credit score stable. As soon as you clear a credit card bill of ₹2 lakh, your credit utilization will instantly come down to zero and your CIBIL score will skyrocket within 30 to 60 days.

If you have both the debts, then without wasting any time follow this step by step plan:

1. Stop excess purchases on credit cards immediately: Until the ₹2 lakh bill becomes zero, stop swiping that card or using it online completely.

2. View personal loan top-up or balance transfer options: If you don’t have the money to pay off the credit card outright, top up ₹2 lakh on your existing personal loan at 13-14% or get a balance transfer from another bank at 0% to 12% and eliminate the 42% credit card outright the same day.

3. Put Personal Loan EMI on Auto-Debit: Never default on your monthly personal loan EMI of ₹17,000 to avoid late penalties and bounce charges.

4. Prepayment of personal loan after credit card expiry: Once the credit card balance of ₹ 2 lakh is paid off, start depositing the additional monthly savings as pre-payment towards the personal loan principal amount every month, so that the 3 year personal loan will be completely exhausted in 18 to 24 months.