Almost everyone uses a credit card at some point, but not everybody really understands how they work. This, unfortunately, can lead to hefty credit card debt when you make purchases without really understanding how to properly manage credit.
How common are credit cards? There are approximately 76.2 million Visa and MasterCard credit cards in circulation in Canada. With a population of 36.99 million, that means the average Canadian has at least two credit cards.
Managing credit cards is an important skill to have. Whether you’ve just applied for your first credit card or you’ve been using them for years, it’s important to understand how they work, what happens when you don’t pay your credit card balances in full, and the impact of compound interest.
What are the risks of using credit cards? How does a credit card work? What’s the smartest way to use a credit card? It’s important to know the answers to these questions (and more) so we can use credit cards in a way that helps us move forward—not backwards—in our financial journeys.
What to Know About Credit Cards
The key to effectively managing your credit card (or cards) is understanding them. It’s important to know what the lingo is that the credit card company uses and what it means. This way, you can better understand how it all affects you.
Here are a few key things to know about credit cards:
1. What Is APR?
APR is an acronym for “annual percentage rate,” which is the amount of interest that your credit card balance will accumulate over the course of a year. For example, if your APR is 25% and you have a balance of $4,000, then you would expect to pay $1,000 in interest by the end of the year.
However, APR is a bit more complicated than that because it can be compounded daily, semi-monthly, monthly, semi-annually etc. depending on the lender. Most credit cards compound interest daily. That means that while the total interest charged would equal 25% over the course of a year, a small part of that is applied every day.
The basic formula for determining daily interest is to take your APR and divide it by 365 (the number of days in the year—though some lenders base it on 360 days). So, the daily interest on a 25% APR would be about 0.0685%. Applied to a $4,000 balance, that’s about $2.74 dollars a day.
Not bad, right? Not so fast.
Since the interest compounds every day, the amount you’re charged grows each day. 0.0685% interest on that additional $2.74 interest charge isn’t much (an extra 0.2 cents, rounded up to the nearest tenth), but remember that this happens thirty times every billing cycle. By the end of the month, you’d have well over $80 in interest added, and the growth rate of that interest would increase every day since the interest charged would be based on the new, higher total.
This is one of the more confusing aspects of credit card ownership—one that has tripped up many people and led them into debt!
2. What Does Compounding Interest Mean?
Compounding is a term related to interest that means that when interest is assessed, it is based on the new balance of the account after any previous interest charges have been added. In other words, compound interest means earning interest on top of previously-accumulated interest charges.
For example, let’s say someone has a balance of $1,000 on their credit card and their interest rate is 25%. If they failed to make a payment on their credit card, their $1,000 balance would grow to $1,020.83 on their next credit card statement, assuming no new purchases were made.
If that same person fails to make a payment on their credit card the following month as well, then their next credit card statement would show an opening balance of $1,042.10 (again, assuming no new purchases were made). So the 25% interest is being calculated on the last statement balance of $1,020.83—not the original $1,000.
This is how compound interest works when it comes to credit cards. If you have an outstanding balance on your credit card, you pay interest on top of the accumulated interest charges, too—not just on your purchases.
This is one of the risks of owning a credit card, which many people underestimate until it’s too late. The good news is if you’re able to pay down your credit card each month, you can minimize or even avoid compound interest entirely.
3. Credit Cards Have Grace Periods
Compounding daily interest sounds scary, but it doesn’t have to be. This is because regular credit card transactions have a grace period (usually 21 days) where you're not charged any interest, starting on the last day of your billing cycle.
For example, let's say you used your credit card this month, and you get your credit card statement on the first of next month. That means you'll have 21 days starting on the last day of this month's billing cycle to pay off your credit card bill without being charged any interest.
So if you pay the balance in full by the due date, you can avoid being charged any interest entirely while using your credit card.
It should be noted that cash advances are an exception to this grace period. With those, you’re charged interest from the moment you made the advance until it is paid. Additionally, interest rates on cash advances are often higher than regular transactions.
4. What Are Cash Advances?
When you skim through the pamphlet that comes with a credit card application or the card company’s online application form, you may notice a section on “Cash Advances". This section explains that there are different terms and restrictions for cash advances versus regular credit card transactions.
A cash advance is when you use your credit card to withdraw money from an ATM. Or if you transfer funds from your credit card to your bank account that’s also considered a cash advance. Most people assume that a cash advance with a credit card is no different than withdrawing money from your bank account using your debit card, but that's not the case.
For example, as mentioned earlier, the interest rate on a cash advance is typically higher than it is for regular credit card transactions. Also, cash advances don't have an interest-free grace period. That means when you take out a cash advance you’re immediately charged interest until the cash advance is paid in full. There may also be additional fees for cash advances.
If you haven’t reviewed the terms in your credit card agreement regarding cash advances, you may want to do so as soon as you can. It can be incredibly useful for helping you determine if a cash advance is worth it.
Generally speaking, it’s a good idea to avoid taking out cash advances if you can. You’re better off withdrawing any cash you need using your bank’s debit card at an ATM or going to a retailer that takes debit and offers cashback.
If you don’t have the funds available for a cash withdrawal in your bank account, consider putting off the purchase until you do have the funds or look for alternative retailers who accept credit instead of cash, if possible.
5. Credit Card Spending Limits
One of the first things you’ll probably want to know about your credit card is its spending limit. This tells you how much money you have access to on the card before you start encountering issues like transaction rejections, extra fees, and other penalties that may vary from one credit card to the next.
Credit card companies in Canada are not supposed to increase your credit limit without your express written or verbal consent—but some foreign card companies may try to do so without telling you.
In general, it’s best to avoid going too close to your credit limit because:
- Having the extra leeway could help in an emergency.
- Low balances reduce how much you pay in interest.
- Having a low credit utilization rate is good for your credit score.
6. What’s an Introductory Period or Offer?
If you’ve seen an advertisement for a credit card, odds are you’ve seen the term “introductory period” or “introductory offer” somewhere in the ad. An introductory period is a special low-interest rate that credit card companies offer to encourage you to sign up for their card.
For some, introductory offers can be a tool for helping them get out of debt. For example, they can transfer the balance from their other, higher-interest debts onto a new credit card with a low introductory interest rate. Then, they focus on paying down the debt before the introductory period ends.
This strategy can help save money in interest. Just be sure to check the interest rate on balance transfers during the introductory period because it may be higher than it is for regular transactions.
When signing up for a credit card, be sure to ask what the introductory period rate is, how long the rate will be valid for, and what the rate will be at the end of the introductory period. Credit card companies are supposed to provide this information up front, but it never hurts to verify.
7. What Happens if I Miss a Payment?
The penalties for missing a payment may vary depending on the credit card company, how much money you owe, whether you’ve missed any previous payments and the specific terms of your credit card agreement.
For a first-time tardy payment, the penalty is usually an interest charge tacked onto your next bill. This can also result in a note about the late payment being added to your credit report, which can hurt your credit score.
Some credit card companies may also warn you that your interest rate might increase if you do not make a payment—which can make it even harder to get control over your debt. If you’re using a credit card with an introductory period offer that reduces your interest rate, the credit card company may prematurely end the introductory period.
If you cannot pay your credit card bill in full each month, it’s important to at least pay the monthly minimum on time to avoid excessive charges.
8. You Can Use Secured Credit Cards to Build Your Credit
For many who have struggled with debt in the past, a damaged credit score is all too common. Events like missed payments, filing for insolvency, and maxing out your credit can all make financial institutions less willing to work with you.
This may mean having to put up with less than favourable terms in loans and other financial service contracts. However, there are ways to rebuild your credit—and using a secured credit card is one of them!
A secured credit card is a bit different from a “regular” credit card. With a regular credit card, you are provided access to a revolving line of credit that has a set limit. With a secured credit card, you provide a security deposit as a form of collateral. Sometimes the credit limit on the secured credit card is based on the security deposit amount. So if you provide a $300 security deposit, your spending limit would be $300.
Secured credit cards are easier to get for those with a low credit score since the card issuer is given collateral to let them recoup their losses if payments are missed.
Note that secured credit cards are very different from prepaid credit cards. Secured credit cards act like regular cards since you’re borrowing from a lender (which is why they can help you with building your credit history and score).
Prepaid credit cards act more like gift cards that you can use anywhere the credit card network’s regular cards are accepted—you pay a set amount of money to “load” the card and you’re good to go. Since you aren’t borrowing money from a lender, a prepaid card doesn’t tell financial institutions anything about your borrowing habits.
Instead of helping you to build credit, prepaid credit cards are more useful for helping you stick to a set budget (or teaching your kids how to spend responsibly).
9. What Are the Different Types of Credit Cards?
There are many different types of credit cards available to consumers these days. Some of the different credit card categories include:
- Secured Credit Cards. As mentioned earlier, these are credit cards that are secured with a deposit as a form of collateral. They’re often easy to qualify for and can be helpful for building or rebuilding your credit when your credit score is low.
- Unsecured Credit Cards. The typical card that most people think of when they hear “credit card.” This is the term for a card that gives you access to a revolving line of credit that you can borrow from to a maximum limit.
- Prepaid Credit Cards. Less a “credit card” and more of a gift card that can be used wherever the card network’s logo appears. Prepaid cards are sometimes reloadable at the merchant where they were initially purchased.
- Debit Cards with Credit Card Logos. Instead of accessing a revolving line of credit, these cards pull funds from your bank account. They work just like a regular debit card except they’re accepted wherever the credit card logo on the card is accepted. So in places where you normally can’t make purchases using debit, you can if your debit card has a credit card logo on it which the merchant accepts.
- Business Credit Cards. A credit card meant for use by a company. These cards can help your business build a separate credit history to access business-oriented financial services later—though the initial application often relies on your own credit. They’re also helpful for tracking business expenses for tax purposes.
- Rewards Cards. Less a type of credit card and more of an add-on to credit cards. These credit cards offer you some kind of reward for using the card—such as airline miles, cash back, hotel credits, and store-specific incentives for locations the card network partners with.
- Store Credit Cards. Cards that are branded for a specific store chain or network of businesses owned by the same parent company. These cards are often easy to obtain and have strong store-specific rewards and incentives. However, they may be limited to that one store chain or set of related businesses. Co-branded cards are similar to store cards but may be used at other locations (though they often offer better rewards/incentives for shopping with the brand on the card).
Need Help Managing Credit Card Debt?
Even someone who makes a lot of money and is well-informed about how credit cards work can find themselves amassing more debt than they can handle on their own.
If you find yourself struggling to manage your credit card debt, reach out to Credit Canada today! Our certified Credit Counsellors are here to provide help and advice to get you debt-free.
Want to know more about your debt situation? Get started with our free online debt calculator tool!