August 2006

Credit cards – yours to use or abuse

Our discussion on interest so far has focused mainly on what impact increased interest rates can have on your finances, whether you have debt or savings. Now we come to one of the most used and misused forms of electronic finance today – the credit card.

This small piece of plastic has so much power. It can either be a very useful tool, or it can devastate your personal finances, mainly because of our current topic – interest!

Credit cards have some great advantages. A credit card in your wallet can replace huge wads of cash. A credit card offers you an easy way to track expenses, as your monthly credit card statement itemises each purchase. And if you want to buy something now but don't have the cash for it, whipping out your credit card secures the deal.

They offer convenient and accessible credit. But convenience and accessibility come at a high price, and that price is called "interest". Interest charged on credit card transactions is much higher than interest charged on a home loan, for example. This is because credit card debt is "unsecured", whereas home loan debt is "secured" – meaning that, if you fail to pay your home loan, the bank can repossess your home (i.e. your home acts as security against your debt).

With credit card debt, there is no backing security, which means that credit card debt is high-risk for banks.

Money Matters as far back as 2003 discussed debt management. Naturally, credit cards came under the spotlight. We said: "The only way to manage a credit card is to pay the full amount owed each month. Paying the minimum amount each month is disastrous. If you can't pay the full amount you owe each month, you should not have a credit card."

We still stand by that statement. An example will show why. Let's say you spent R2300 on your credit card in August. On your card statement you'll see (in bold print, just to make sure you don't miss it), that the minimum payment required is R115. Wow, you've spent R2300 but you only have to pay R115 – only 5% of what you owe! What a great deal!

But you have to look quite carefully to find the catch: "If you don't pay the full balance (i.e. R2300) by the Payment Due Date, you will be charged interest on purchases shown on this statement and on any new purchases, from the date of the purchase." (italics ours)

Of course, you have to look even more carefully on your statement to find what interest rate you will be charged (tip: it's written quite small at the very bottom).

Let's say it's 17% per annum. Seventeen per cent interest on R2300 is R32 for the first month. So, if you don't pay the full balance, R32 will be added to what you owe. And remember the note in italics above – not only is interest charged on your current balance, it will also be charged on any further purchases!

Carry on for a few consecutive months paying only the minimum payment required each month, and you will be paying interest on interest (the miracle of compound interest we spoke about last month becomes less exciting when applied to interest charged on interest charged on debt).

If you spent R2300 per month on your credit card and only pay the minimum of 5% each month, you would owe the bank more than R12 000 at the end of six months.

It's hard to avoid paying interest on a car or home loan. But to pay interest on the purchase of consumables – which is what credit cards are usually used to buy – is truly a waste of money. It's possible these days to get several credit cards or store charge cards in your name, with a credit limit that exceeds your annual income!

Unless you can be very disciplined with a credit card, rather go without and use a debit card instead (more of that in the next issue). Incidentally, your credit card can be used as a form of savings, because if you are in credit on your credit card, you will earn a small amount of interest.  

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