Wednesday, 12 November 2008

Credit Cards - What you need to know

What You Need to Know about Credit Cards.

If you’ve been thinking about moving house and have been put off by thoughts of a higher mortgage and how that may affect your lifestyle, it could be an opportune time to look at your current expenditure, not only what you’re spending, but also where are how you’re spending it. Credit card debt is the most expensive form of financing available, and although quick and easy to use, there are ways and means of reducing your expenditure and freeing up your cash for more worthwhile endeavours for example, how much do you actually know about the rate your being charged and how it’s calculated on your card? Understanding just how interest rates work can help you see how important small differences in rates and payment amounts can be.

Interest Rates are Compound.

It is important to remember that what you owe is compounded – that means you pay interest on the interest you owe from the month before. That means that if you’re paying 2% per month in interest, you’re not paying 24% per year – you’re actually paying 26.82%. Charging interest monthly instead of yearly is a trick to make it feel like you are paying a very low price for your borrowing.

A Thought Experiment.

Here’s a question: would you rather have €1 million, or €10,000 in a savings account earning 20% per year in compound interest?

Well, let’s see how that €10,000 would grow. After 10 years: €61,917. 20 years: €383,375. 30 years: €2,373,763. 40 years: €91,004,381. 50 years: €563,475,143.

So after fifty years, you’d have over €500 million?! Well, not so fast. Of course, you have to take inflation into account – if we say inflation is 5%, then that money would have the buying power that €10,732,859 does today. Still, that’s not a bad return on your investment of €10,000, is it?

That’s the power of compound interest, and the way the credit card companies make their money (it’s also the way pensions work, and the reason the prices of things seem to rise massively as you get older). Be very, very afraid of compound interest. Or, of course, you could start saving, and be very glad of it…

Compound Interest Adds Up.

Let’s work through an example on a more real kind of scale. Let’s say you have an average unpaid balance of €1,000 on a card at 15% APR.

You will owe €150 in interest for the first year you borrow. However, this amount is then added onto the balance, and interest is charged on that. The second year, you’d owe another €172.50, for a total of €1322.50. It goes on, with totals like this: €1,520.88, €1,749, €2,011.35.

After just five years at 15%, you’d owe double what you borrowed. And after 10 years, you’d owe four times what you borrowed! Bet you weren’t expecting that. If you let something like that carry on for long enough, you’ll end up paying back that credit card for years afterwards, paying back what you borrowed many times over and still not clearing the debt. Most people don’t work this out, and feel that the payments must simply be their fault for spending too much money to begin with.

One Percent of Difference.

One more thing. You might think there’s not that much difference between a card that charges 15% APR and one that charges 12% APR. Let’s see the difference the lower rate would make to that €1,000 borrowed for five years. Remember, after five years at 15%, you owed €2,011.35.

At 12%: €1120, €1254.40, €1404.93, €1573.52… €1762.34 after five years. So you’ve saved €249.01 from that 3% difference in APR – in other words, you’ve paid almost 25% less interest.

When you’re dealing with credit cards, you’re playing with fire. Unfortunately, there are plenty of people out there who don’t realise that, and make all sorts of dangerous mistakes with their credit cards every day.

Paying Late.

If you don’t set up any kind of automatic payment, then it can be tempting to just put your credit card bill on a pile and get to it when you have time. Before you know it, a few weeks have gone by and you’re late. If you leave it to the deadline, you might find that the payment won’t get there quickly enough – it’s not a deadline for sending the money, it’s a deadline for them receiving it.

Paying late is a big mistake for an awful lot of reasons. You will almost certainly be charged a late payment fee, and your late payment will go on your credit report for everyone to see. You may also find that you lose any good rate you had, and your debt is automatically thrown onto the very worst rate the company offers.

To avoid late payment, you should always post your payment a long time before the due date (at least a week). If you’ve left it to the last minute, phone up and try to pay that way.

Being Taken in By Rewards.

It is never, ever worth getting a higher-interest card simply because it offers some kind of loyalty points, flight miles or whatever. Even if it offers a cash reward, it is unlikely to be more than you would pay in extra interest – after all, why would they give you free money? All ‘rewards’ do is pay you off with your own money to make you feel like you’re getting something for nothing. You’re not.

Collecting Cards.

Seeing some people opening their wallet or bag is a scary experience. It looks like they have about a hundred credit cards in there, some of which they haven’t used in years. They have trouble keeping track of all the different cards, balances and interest rates. Don’t be one of these people. Too many cards makes you look over-committed in your credit report, and could get you turned down for a home loan.

Maxing Them Out.

Your limit is just that: a limit, not a minimum! Whatever you do, don’t get a card and immediately spend your whole limit. This looks very bad. It is better to spend about halfway regularly and pay it back. Wait for the company to increase your limit (which they quickly will), and then you’ll get that extra money without the stigma of having a maxed-out card.

Not Reading the Terms and Conditions.

Don’t sign anything you haven’t read! I know it’s hard going and you’re busy and all, but if you can’t manage to read the terms and conditions then you shouldn’t get the card. Pay special attention to any future increases in rates, and what kind of fees you can be charged.

When you’re looking at a credit card offer, take a look at the small print – it seems like a maze, but it’s vitally important. With the trend nowadays towards easier-to-read ‘summary boxes’, there aren’t as many excuses for ignoring the terms as there used to be. Anyway, credit card lenders are devious, and there are plenty of things there designed to catch you out – here’s what you should be on your guard against.

Annual Fees.

Even though you’re already paying them interest, many credit cards still charge you an annual fee. It’s not as common as it once was, but it’s still around. You should be especially careful to check for fees on Gold and Platinum cards – even though they’re not that hard to get any more, they still tend to charge much higher fees than normal cards.

Penalty Charges.

Pay attention to what kind of fees you’ll be charged for a late payment, or if you take a cash advance, or if you accidentally exceed your limit on the card. Some cards have unjustifiably high fees, and you shouldn’t sign up for them.

Interest Method.

This is one of the most overlooked of all the things in the small print, just because it’s so hard to understand. Essentially, every company has a slightly different way of working out how much interest you should pay each month. There are three main methods:

With the ‘adjusted balance’ method, you are charged interest on whatever your balance was when the company sent the bill. Another version of this is the ‘previous balance’. You’re charged interest on your balance as it stood at the end of the billing cycle before this one, regardless of how much you’ve spent or paid off since. Odd, but easier to understand.

Then there’s the average daily balance. This is the most complicated, but also the most common now. Your balance from the end of each day in the billing cycle is added up, and then divided by how many days there were, and interest is charged on this amount. This method is only good for you if your balance jumps around a lot, as it avoids you paying lots of interest on a balance that just happened to be large on the billing date.

Also, make sure you look at the rate of interest each month, they can change.

Grace Period.

Check that the card you’re looking at has a grace period on purchases. Otherwise, you could end up being charged interest from the minute you spend. Almost no cards have a grace period on cash advances or credit card cheques, however.

Currency Conversion Fees.

If you plan to use your card abroad, you should take a look at how much the card charges for transactions made in other currencies. Some cards can be much more expensive than others.

Take a look at your credit card and how much your spending on it. There are many great offers out there from other providers and by examining them, you may well find yourself saving a lot of money.