About Credit Cards

About Credit Cards

What is a credit card?

A credit card as opposed to a debit card is a way of instantly borrowing money to make a purchase. It enables you to buy something there and then even if you don’t have the money to pay for it. You will obviously have to pay for your purchase at a later date, but that will normally be at the end of the month.

How does a credit card work?

Essentially the card provider is loaning you money, and as with all loans there’s a cost. The card provider charges interest on the loan and rates for credit cards can be high, typically 18%. Each month the card issuer adds up all your spending and bills you for the total. They will tell you how much interest you will have to pay if you don’t clear the debt and what this month’s minimum payment is. You can either pay the bill in full, pay the minimum or anything in between but the interest will continue to accrue on your borrowing. There are penalty charges for late or missed payments and if you continue to fall into arrears the issuer can take legal action and your credit rating will be affected.

Take a look at the following example; Mrs Jones used her credit card over a month but did not pay off her balance in full. Her credit card annual interest rate is 18%. If you divide 18% by 365 you will arrive at a daily interest rate of 0.04931%.

Date Period Daily Spend Interest Owed
1 April to 5 April 2015 £0 for 5 days £0 x 0.04931% = £0
£0 x 4 days = £0
6 April to 30 April 2015 £4,000 for 26 days £4,000 x 0.04931% = £1.97
£1.97 x 26 days = £51.22
1 April to 5 April 2015 £0 for 5 days
£4,000 for 26 days
Total interest owed:
£0 + £51.22 = £51.22

Many card providers offer an interest-free period of up to 59 days, so if you’re able to repay the bill in full each month you’ll pay no interest and effectively the loan is free. Credit cards are a useful short-term stop-gap, but aren’t suitable for long-term loans.

What are the pros to having a credit card?

Quick access to credit - If you unexpectedly need to pay for something a credit card can be handy. For example if your washing machine breaks or your car needs a major repair.
Access to good offers - They can help you secure a good deal by buying early, such as a holiday.
Payment protection - Most card providers offer free payment protection on purchases between £100 and £60,260. If your purchase is faulty or the company you’ve bought from goes bust the issuer will refund your money. This makes them a good option when buying online.
No borrowing fee - If you pay the card off each month the borrowing is free.
Loyalty points & cash back - Many credit cards offer incentives such as loyalty points or cash back so if you pay in full each month you really do get something for nothing.

What are the cons?

High interest rates - Interest rates are high so it is not a cheap way to borrow, particularly in the long-term.
Compound interest - If you’re unable to pay the bill in full each month the interest mounts up and you’ll pay far more for your purchases than the original cost price.
Easily accessible debt - Credit cards can make spending too easy, so you must be confident you’re able to repay the money or you could find yourself in financial trouble. It is after all a debt.

How do you get a credit card?

When you apply for a card the issuer will run a credit check on you. Your credit history will be affected by things such as late or missed payments on other credit cards, on mortgages and by exceeding overdraft limits on your current bank account. If you have a poor credit rating the card provider may refuse your application or indicate they will charge you a higher rate of interest. The rate advertised is the ‘representative annual percentage rate’ and must be offered to at least 51% of people, meaning 49% can be charged a higher rate. Your credit rating will also dictate the credit limit on your borrowing.

Do credit cards have annual fees?

Some cards have an annual fee so check the small print. This is sometimes accompanied with benefits such as free travel insurance or reduced costs for foreign exchange.