Credit cards are borrowing instruments, unlike debit cards where you already have the money. Banks are there to make money too. Just like high street stores, they hope to maximise their profits within the rules. So it’s important to understand the basics and find a credit card that’s right for you – you can compare low APR credit cards here.
Now you know the rules, let’s find out how to play the game. The financial services industry charges interest on the money that it lends out. Let us assume you borrow £100 on your credit card and keep it for exactly one year before you pay it back. For the purposes of this article, we will assume your loan attracts 8% interest per year, which is the Annual Percentage Rate, or APR for that particular transaction.
If you paid the loan back in one go at the end of year one, you would owe them £108. That is, your original £100 plus 8%. The bank will likely ask you to pay the interest monthly though. Divide £8 by 12 months, and you get 67 pence a month (well 66.66 pence if you insist). If you decide to repay the loan back after six months – but paid no monthly interest – then you will owe them £104. When you think about it, the APR will still be 8% per full year.
Let us try something different. Suppose you paid back £50 after 6 months. In this case, your situation would look like this:
• First six months, interest added £4 (capital sum £100)
• Second six months, interest added £2 (capital sum £50)
The total interest of £6 you pay is only 6% of the money you originally borrowed. But then, you did give them back £50 halfway through, which is why there is a saving of £2 overall. Moreover, you only have to scratch around for £52 at the end of the loan period. It always makes sense to pay a loan off quicker.
Of course, if you fall behind on monthly interest payments (or fail to pay the loan back on time with interest) then the situation will look different. Now here is a hot tip. Some card firms with the lowest advertised APRs charge the highest penalty interest rates, if you are late with payments. So pick your service provider with your own plan in mind.
Using a credit card for purchases
Pretty much the same logic applies: if you keep up with payments and do not overspend, your situation should stay under control. If you do not though, the interest can spiral out of control to the extent that you can hardly keep up with it. Yet another good reason not to use your credit card for luxuries like beer and holidays.
Is the lowest APR the best?
Not necessarily. Here are some tips that will help you make the right and most informed decision:
• Only half the customers that apply get advertised APRs. Learn to look for terms like “representative” and “average” in advertisements.
• In practice, credit card firms do creditworthy checks, analyse our individual payment records, and then apply an APR that balances out their risk.
• Be wary of choosing a particular card because of the “free” add-on rewards. You have to spend money to qualify for them, meaning they’re not free after all.
• Aim to pay for your purchases every month, and repay your loans on time. If you do not, be sure to compare the penalty interest rates you will end up paying.
So is a credit card a bad thing?
Definitely not, credit cards have many benefits. These include a plan in hand for unplanned expenses and detailed statements so we can see where every pound we spend goes. That said it is important to use a credit card responsibly, so you stay out of financial trouble, and avoid that dreaded bad credit record.
Finally, a quick word on whether to have a credit card at all. In the UK, you can seldom borrow money if you do not have a record of previous credit. This can be a real bind when you need a mortgage to buy a house. A clean credit card is the perfect way to build your reputation. Just choose the APR most suitable for you.