Money & Career

5 essential facts about how credit cards work

Author: Canadian Living

Money & Career

5 essential facts about how credit cards work

Canadians are carrying a staggering amount of debt -- almost $1.50 for every post-tax dollar in 2009, according to Statistics Canada. A lot of this is consumer debt, including credit card debt. Credits cards are not inherently evil, but they can cause a lot of damage in the wrong hands. And while abusing your credit card makes your financial adviser very unhappy, it makes credit card companies very happy -- because they're making a lot of money from your spending habits.

When properly used, credit cards can contribute toward a very good credit score, which helps you buy bigger items like a house. If you don't understand how credit cards work, they can lead to crushing debt and a lot of stress, so here's our quick and easy guide to how credit cards work.

1. Interest
You're borrowing money when you use a credit card. As with all loans, you have to pay interest -- an additional fee above what you borrowed -- which is the cost of paying for purchases over time. The longer you take to pay off the debt, the more interest you'll pay -- which is money the credit card companies earn for having lent you the money.

There is a period when credit card companies allow you to pay back the borrowed money with no interest. This is called a grace period. The grace period varies from 21 days to 30 days depending on the company and the card agreement. Usually, if you pay off your balance from purchases by the payment deadline each month, you won't have to pay interest.

2. Minimum payments
The minimum payment is the least amount you can pay monthly on your credit card debt before incurring a late fee. This doesn't mean you're getting rid of your debt -- or avoiding interest. Your payment goes first toward paying off that month's interest, and then any remaining amount -- which is usually quite small -- goes to the principal.

The minimum payment is usually calculated based on your principal owing, interest rate, credit limit and credit score.

If you think you're managing your money by paying just the minimum monthly amount, think again. By doing that, you're paying far more than the cost of your purchase. Take a look at your next statement and see how long it will take to pay off your card if you make only minimum payments. Frightening, isn't it?

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3. Late payments
Making late payments can adversely affect your credit score, especially if you do it more than once. If it's the first time, you can talk to your credit card representative and they might waive the fee. If you make late payments more than once, you will get charged a late fee and could end up with a higher interest rate. 

4. Cash advances
A cash advance is when you use your credit card to withdraw cash from the automatic bank machine. We strongly suggest you don't get into this habit. For one thing, you get charged a whopping interest rate. In addition, there's no grace period. As soon as you withdraw that cash, you're getting charged interest. 

Only use a cash advance if you have exhausted every other reasonable avenue. 

5. Balance transfers
You might be tempted to get a new credit card with a lower rate and transfer your current credit card balance in the hopes of paying less interest. In theory, this could work for you, but there are a few caveats. 

Read the fine print before you take action. The important thing to notice is the length of time you have with the lower-interest card. If you're able to pay off your balance during that time, then consider transferring your balance. If not, check and see if you'll end up with a card with a higher interest rate in the end. Remember, interest rates almost always go up on credit cards. Also check for fees and any other additional costs.

Credit cards are not replacements for cash and they're not evil. They're inert objects but they do offer a great deal of temptation. It's how we handle that temptation that leads us to the depths of consumer debt or the heights of financial responsibility.

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5 essential facts about how credit cards work

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