When you borrow using a credit card and do not pay off the balance each month, you pay interest. In fact, you pay a particular type of interest called compound interest.
A lot of people do not understand how credit cards really work. In fact, across Ireland, when it comes to the cost of credit, most people are in the dark. Successive national surveys show that over half the population own a credit card. But many are unaware of how much they pay or how the interest cost really works.
So, using a simple example of a purchase of €500 using a credit card, if your credit card company charges 18% (fairly typical) and the minimum payment is 2.5% of the outstanding balance, this means it could take over 11 years (11 years and 7 months to be precise) to pay the balance off in full. This is assuming no other charges are added to the credit card balance.
The time to repay the outstanding balance on the credit card is just one issue; the total cost of credit is the other.
In the case of the €500, the full cost of credit is €457, which is based on the cost of interest (18%) and the minimum payment.
To make this easy, the total cost to the credit card user in this case is the original €500 PLUS the €457 cost of interest for a grand total of €957.
CONVENIENCE, NOT VALUE
Credit cards can provide a convenient source of ready-credit for would be shoppers. However, the convenience they provide should not be confused with value, especially where a balance in not repaid in full before the payment due-date.
What credit card users should do is look for ways to repay their credit card balances as quickly as possible which they can do a number of ways:
- Pay off the full balance on or before the Due Date, this means they avoid paying any interest on the outstanding balance.
- Pay off the balance on instalments – if they do not have the available cash to repay the full balance, they should look to repay the outstanding balance over a set period of time, while they will still pay interest as long as there is a balance, the cost will be far lower than making a minimum monthly payment.
- If they have considerable credit card debt, they should consider a debt consolidation loan. The one thing to watch with a debt consolidation loan is the repayment term is kept as short as possible to ensure the total cost of interest is kept to a minimum.
There is no doubt that credit cards can be a really handy source of payment, especially when shopping online, they can also provide a level of security against fraud that some people may prefer than risking their debit card security. But they can, where the minimum payment is relied on, be a very expensive form of borrowing.
Frank Conway is a qualified financial adviser and founder of MoneyWhizz, the financial literacy initiative. MoneyWhizz financial well-being seminars are now available in Ireland’s leading employers. Financial education programmes are available across Irish Primary and Secondary schools.