Credit cards – friend or foe?

Credit cards offer a convenient alternative to carrying cash or using cheques. If used sensibly they can be a great friend. But there are many traps and, unless you use your card wisely and with discipline, it will quickly become your foe. This article provides tips on how to choose the best card for you and how to use your card wisely. As the saying goes, ‘the devil is in the detail’ so, with credit cards, it pays to understand the fine print.

Credit cards, best cards, fine print, balance, questions, shop around, interest rates and fees, repayments, rewards, control, insurance, louise biti, strategy steps, infochoice

Credit cards offer a convenient alternative to carrying cash or using cheques. If used sensibly they can be a great friend. But there are many traps and, unless you use your card wisely and with discipline, it will quickly become your foe. This article provides tips on how to choose the best card for you and how to use your card wisely. As the saying goes, ‘the devil is in the detail’ so, with credit cards, it pays to understand the fine print.

Choose the right card type

Financial institutions and stores offer a range of credit cards with varying interest-free periods and rates, reward programs, fees and other conditions or offers. The best card for you depends on how you plan to use the card.

Step 1: Ask – can you pay the balance every month?

Do you want a credit card mainly to provide a convenient way to shop or do you need it to provide short-term loans? The answer to this question can help you to choose between a card with an interest-free period or no interest-free period.

Cards with an interest-free period effectively provide you with a free loan for that period. But the interest-free period only provides a benefit if you pay the balance in full (see the section on forfeiting the interest-free period). If you do not intend to pay the full balance each month, the lower interest rates on cards with no interest-free period may offer a better deal for you.

Step 2: Shop around to compare interest rates and fees

Shop around to compare interest rates, fees, reward programs and other features. A financial institutions lists credit cards and current rates on its websites so you can do a lot of the research from the comfort of your home

Tip: Visit www.infochoice.com.au for credit card comparisons which will help you narrow down the options to a short list of cards which suit you. Always verify details with the provider.

As a general rule, cards with reward programs generally charge higher fees and/or higher interest rates. So you should determine whether the rewards really offer enough value (see the section on reward programs). The interest rate on credit cards varies widely and, in most cases, you can expect to pay rates a lot higher than your home loan. A comparison of interest rates (at 8 February 2009) showed a range from 8.99 per cent to 20.74 per cent. Some cards have two levels of interest rates – one rate applies to purchases and a higher rate applies to cash advances.

Step 3: Use this checklist
When choosing a credit card, use the checklist below to compare the features:
• interest rate on purchases and cash advances
• number of interest-free days
• reward programs
• annual fees
• other fees and penalties – e.g. late payment fees
• availability of discounts or free benefits
• type of card – i.e. Visa, Mastercard, American Express,Diners Club etc. (some types are not as widely accepted and may incur higher transaction fees)
• minimum credit limit.

Forfeiting the interest-free period

If an interest-free period applies it is usually 55 days but some cards offer a shorter period. Provided the balance on the statement is paid in full by the due date, no interest applies to purchases. The interest-free period does not apply to cash advances so they accrue interest from the date the cash is taken.

If the balance is not paid in full by the due date, the interest-free period is forfeited and interest is charged on all
transactions on that statement from the date of purchase until paid. Transactions which occur after the due date also do not qualify for the interest-free period.

A higher interest rate may apply to cards with an interest-free period so they are better suited if you plan to pay off the full balance each month, not just most of the balance (see the following example on forfeiting the interest-free period).

Example: forfeiting the interest-free period
Anne has a credit card with a 55-day interest-free period and an interest rate of 18.75 per cent per annum (0.053808 per cent per day). Her July statement showed a closing balance of $1284.97. Anne normally pays the balance in full but she was a bit short this month and only paid $1240, leaving an outstanding balance of $44.97.

Anne did not realise that she had forfeited the interest-free period and interest is charged on all purchases in her July statement from the date of purchase. The daily interest rate is applied to the average daily balance throughout the month. Interest for July: $1,958.47 x 0.053808% x 32 days = $32.20 This interest was added to her August statement. In addition, all new purchases accrue interest from the purchase date until the balance is paid in full. So also added to her statement was interest for transactions in the August statement. Interest for August: $1382.21 x 0.053808% x 30 days = $22.31 In this example, leaving an unpaid balance of $44.97 on the July statement resulted in an interest charge of $54.51. Anne paid the full balance showing on her August statement before the due date so the purchases on the next statement can again qualify for an interest-free period.

Source: Calculations based on an actual case. Names have been changed.

Reward programs
If a card offers a reward program you earn points for certain transactions. These points can be converted into a range of benefits depending on the offer. The points may be converted to frequent flyer points with airlines or used to purchase goods or cashback refunds. The fees and interest rates on these cards are often higher. So, unless you spend a lot on your cards and pay off the balances quickly, it may be cheaper to avoid the programs and use the savings to buy the goods yourself.

Example: Belinda compares two credit cards from a major bank to determine the value of the rewards program. Both cards have a 55-day interest-free period.

The reward offer allocates one point per dollar spent. The points can be used to purchase a range of products, but Belinda likes the cashback option which gives $1 cashback for 200 points (a minimum number of points applies). For example, to receive $80 cashback, she needs to spend $16,000 and accrue 16,000 points. The real value of this program depends on how much Belinda spends on her card and whether she pays off the full balance. The interest rate on the card with the reward program is 7.5 per cent higher and the annual fee is $11 higher.

Making repayments
An attraction of credit cards is that the minimum payments can be low so the debt seems affordable. This is a dangerous trap. Repayments on a home loan or a personal loan are calculated so you pay off the debt over a fixed number of years. Credit cards do not work the same way. Credit card statements merely specify a minimum payment required each month, often as low as 2 per cent of the outstanding balance or a low dollar amount.
If you only pay the minimum amount, you may be surprised how long it takes to repay the debt and how much that holiday or new television really cost you.

Example: the cost of credit card debt
Trevor uses his credit card to pay for a $2000 holiday. He thinks this is affordable because even though the interest rate is 18.5 per cent per annum he only has to pay a minimum monthly payment equal to 2 per cent of the outstanding balance (or $25 if higher). The minimum payment starts at $40 per month and reduces over time as the balance reduces. Assuming Trevor never spends any more on this card and just pays the minimum, he is shocked to realise that it will take 33 years and five months to repay the $2000 loan – at a total interest cost of $5530.

The tip with credit cards is to pay off as much of the balance as you can afford each month. If Trevor doubles the first payment and pays $80 every month, the loan period is reduced to two years and nine months and he only pays total interest of $546.

Credit card insurance
Some credit card providers offer optional consumer credit insurance (CCI). If you become unemployed or disabled, the policy pays part of your monthly balance for a set period. If you die, CCI may pay your balance up to a set limit. You will be charged a fee for the cover, depending on your outstanding monthly balance. Before taking out this cover, read the policy carefully and decide if the cost of the insurance is worthwhile.

Keeping your cards under control
It is easy to get into trouble with credit cards and build up levels of debt that you can’t afford. You need to have discipline and understand the fine print.
Tips to avoid disaster
• Avoid the temptation to accumulate more than one or two credit/store cards.
• Use a debit card so you spend your own money, not borrowed money.
• Pay off as much of the balance as you can afford each month.
• Tear up any offers in the mail for automatic balance increases or new pre-approved cards.
• Make payments on time to avoid late payment fees.
• Check if the store or merchant charges you a fee to use your card – some of these fees can be quite large. If a fee applies consider other payment options such as debit card or biller payments through BPay.
• Transfer balances to a low interest credit card and keep the payments as high as possible. If the interest is only low for a ‘honeymoon’ period, check by how much it will increase at the end of the period.

Disclaimer: The information in this article is general and does not take into account your particular circumstances. We recommend specific tax or legal advice be sought before any action is taken and refer to the relevant Product Disclosure Statement (PDS) before investing in any product.

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Louise Biti is principal of Strategy Steps, which provides strategy support to financial planners.
To compare credit card costs and conditions visit www.infochoice.com.au.
Use the credit card calculator on FIDO, the consumer website for the Australian Securities and Investment Commission (ASIC) to calculate the time it takes to pay off a debt at various repayment levels.

Financial counselling services can help if you are having problems managing debt.
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Victoria - Ph 1300 55 8181 (Consumer Affairs)





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