KNOW THE RULES
How credit cards work
Choosing the best card for you
Credit cards are an ongoing ‘line of credit’ that let you borrow money. You can use them for purchases and cash advances. You can repay the full amount borrowed each month or carry over part of the balance to the next month, with interest charged on the amount outstanding. This balance is then carried over to the following month, together with any new purchases.
Credit cards can be extremely useful and convenient. They are more secure than cash in your wallet, and can be handy when traveling – especially overseas. But they make it easy to build up debt quickly.
Using a credit card wisely involves choosing the card best suited to you, minimising the cost and keeping track of how much you owe.
The card that’s right for you will depend on your spending and repayment patterns, and whether you want to earn reward points. So, before you select a card, work out how you intend to use it.
If you already have a credit card you will have a good idea of your repayment patterns. If you are new to credit cards, you need to look at your current spending and budgeting habits to see how you would manage a card.
Do you pay your card off each month?
Card users who pay the full statement balance of their card each month by the due date are known as ‘transactors’. If this sounds like you, the interest rate will be less important, so opt for a card offering a generous interest-free period – usually 40 to 55 days. The date from which the interest-free period commences varies, being either from the date you make a purchase, or from the card statement date.
Payments need to be made by the due date or you could lose the interest-free period altogether – and potentially be hit by a late payment fee.
Do you carry over a balance each month?
These card users – also known as ‘revolvers’, pay only the minimum monthly repayment, carrying over some debt from month-to-month. This means you are likely to pay interest on the outstanding balance, so aim for a card with a lower interest rate.
Are you interested in a reward program?
Credit cards tend to come in two varieties: ‘No frills’ cards and those offering reward programs.
Basic, ‘no frills’ cards often have a low rate of interest, making them ideal for card users who continually carry an outstanding debt. They can also be a good idea if your card has a low credit limit as you may be unlikely to rack up sufficient worthwhile reward points. Note though, some no frills cards do provide free reward programs, most notably ‘instant’ rewards (see below).
Other credit cards provide incentives for customer loyalty through a variety of reward programs. The main types of reward programs are outlined below, but bear in mind these sweeteners often come at the cost of higher interest charges and annual membership fees. Be sure you will get value for money from these reward programs before signing up for one.
Don’t be tempted to let rewards influence your spending. Be aware too that earning rewards or cash rebates may encourage you to increase spending on your credit card.
You may be able to get discounts with selected merchants when you pay with your credit card. Your card provider will provide a list of outlets where these ‘instant’ rewards can be obtained, and while there is usually no fee to access these rewards, it still pays to shop around to check that you couldn’t get a better price elsewhere.
‘Cash back’ rewards
Some credit cards will give you a cash rebate based on your level of card spending and/or your outstanding card balance. Depending on your spending pattern, this type of reward can provide a worthwhile discount, but do the sums first to make sure the discount doesn’t come at the expense of a higher interest rate or increased unnecessary spending.
‘Frequent flyer’ rewards
These reward programs let you accumulate membership points based on your card spending. The accumulated points can then be redeemed for free airline tickets.
Many frequent flyer programs charge a fee for program membership, and unless you use your credit card regularly, you may not get value for money from the scheme. The amount of card spending required to earn rewards varies between programs, and there may also be time limits applied to the points you acquire. Some card issuers may also cap the number of points you can accumulate annually irrespective of how much you use your card. If you are a regular card user, it may be worthwhile opting for a card that doesn’t impose this limitation.
Be aware also that it can be hard to redeem your frequent flyer points for travel during peak times like school holidays. This may not be a problem if you can be flexible with your flight dates, but if not, you may be better off paying for your air tickets and accumulating points for other purposes. Some programs allow you to redeem points with an associated travel agent so you can choose your own airlines or travel products (such as tours, or car hire or accommodation).
Another point to consider is your preferred airline. Opt for a card with access to the airline you use most frequently.
Above all, take a good look at the fine print on these reward programs. Make sure you are likely to get value from the program, and don’t let reward points influence your spending habits.
‘Zero rate’ cards
You may come across credit cards offering a zero interest rate on balances you transfer over from an existing card. These offers can sound tempting, but always look at the ongoing interest rate applied to new purchases. If it is far higher than the rate you are paying on your current card, a zero rate card may not be such a good deal after all.
What if you don’t want or can’t get a card?
For younger people who cannot get a credit card, or for those who choose not to use one, a debit card is a good alternative. Debit cards offer the convenience and security of a credit card, but they draw on funds in your bank account, so there is no interest charge.
A combined debit and credit card may offer the best of both worlds. Use the debit card for everyday purchases, and save the credit card for emergencies or to take advantage of discounts on large ticket items.
Fees and charges
The convenience of credit cards comes at a price. In addition to paying interest on any outstanding balance, you may also be charged the following:
How interest is calculated
Interest on credit cards can be calculated in many ways. The most usual are from the date of each transaction, from the next due date or from the date of the monthly statement. And you generally only get the benefit of an interest-free period on purchases if you pay the previous statement balance in full before the due date.
Credit card debt is unsecured (meaning the card issuer has no claim over a specific asset if you can’t repay the debt), so the interest rate is often higher than for other forms of finance. The best way to keep the cost of credit cards down is by paying more than the minimum. Better still, take advantage of an ‘interest free period’ credit card to repay the full amount you owe each month and avoid paying any interest altogether.
Paying only the minimum
The minimum monthly repayment on your credit card is usually set at 1.5% to 2.5% of the outstanding balance or it could be a minimum dollar amount. But sticking to the minimum repayment could see you repaying the debt for some time – with a mounting interest bill.
Consider this: If you make only the minimum payments, a $2,000 balance could take over 15 years to pay off, at a total cost of $2,240. That’s assuming an annual percentage rate of 18%, a minimum repayment of 2.5% with no annual fees charged or additional purchases being made during this time.
Unsolicited offers for more credit
Be wary of unsolicited offers for more credit – they can be a ticket to get deep in debt. If you receive a letter from your card issuer offering an extension of your credit card limit, you need to carefully consider whether you need more credit, and can afford to make the additional repayments.
Getting a cash advance on your credit card can be useful in an emergency. But it can also be expensive. A fee is usually charged either at a flat rate, or as a percentage of the cash advance. Interest starts to accrue immediately once the cash advance is drawn – there is no interest-free period. And your card issuer may regard the cash advance as the last amount you pay off. So even if you repay the amount of the advance the next day, the payment is taken off any pre-existing balance, and interest continues to be charged on the cash advance amounts until the full balance of your card is repaid.
You may come across offers from credit card providers offering zero or low interest rates on balances transferred from other credit cards or store cards. You can usually opt to transfer all or part of your balance from your existing card to the new one, depending on the credit limit available on your new card.
Not only can this reduce your interest bill, it also lets you manage your card debt more effectively if you have more than one card, by combining your debt and paying it off at a lower rate.
The introductory ‘honeymoon’ rate is generally very low – even zero, and it lasts for a specific period, usually around six months. After this, the interest rate on the amount transferred reverts to the card’s ongoing rate.
The amount you will save with one of these offers depends on the rate applicable on the new card compared to your old card. For example, transferring a card balance of $2,500 from a card charging 16% p.a., to a card with a honeymoon rate of 4.5% for the first six months could see you save $141 over the period.
There are some traps with balance transfers though. Check the interest rate that applies to ongoing purchases on the new card. If it is significantly higher than the rate charged on your existing card your savings could be quickly eaten up by higher interest charges. Be aware too that balance transfers don’t usually attract reward points.
Always check the time period of the balance transfer interest rate as not all offers last the life of the balance. In some cases, if the balance transferred is not paid off within the specified period, you may be charged the rate applicable to cash advances on the remaining balance.
The new card issuer will pay out the balance on your old card (it appears as a cash deposit on the card statement), but only you – the cardholder, can close the account. It’s your choice to do this, but arming yourself with more than one credit card could just mean racking up more debt.
Managing your credit card
The following steps can help you manage your credit card wisely:
Consolidating your debt
Credit cards are convenient but the interest charge can be high. If you are facing a mounting credit card bill, it may be better to either transfer your card debt into a new, lower rate card (and cut up your old card), or into a personal loan or mortgage.
Transferring your debt to a new lower rate card could see you saving on interest. Be aware though that the lower rate may only apply to balance transfers – not to ongoing purchases. And check that any introductory rate doesn’t jump to a much higher rate at a future date.
You may opt to transfer your card debt into a personal loan. This can make the debt easier to manage as the monthly repayments are fixed, and the interest rate may be lower. But be careful not to continue spending on your credit card once the debt is paid off, otherwise you could be heading for financial hot water.
Consolidating your debts into a home loan can reduce your overall monthly repayments. However, mortgages are a long term debt - often repayable over 20 years or more, and you could find yourself paying more in interest over the long run than if you simply knuckle down to repay your credit card. For example, consolidating a $5,000 credit card debt into a home loan of $200,000 repayable at 7.5%p.a. over 20 years will add an extra $4,661 to your total interest bill.