Don't Fall For This Card Trick!
Is your credit card one of the many that's unfairly charging its users too much interest?
Credit cards, on the face of it are simple beasts. You hand them over to a retailer to pay for goods, that debt gets added to your account and once every few weeks you get sent a statement telling you how much you owe.
The best way to use cards is to pay off the outstanding balance in full, each month. We can then take advantage of the interest-free period afforded by our cards; as this is between 46 and 59 days it means we could effectively be getting nearly two months credit, interest free. However, many people choose to pay off less than the full amount, with some covering just the 2% minimum payment. This of course is good news for the credit card providers as what's left on your account accrues interest. And when you consider that a credit card APR can be around 15%, while a Best Buy personal loan could be just 5.6%, you can see that credit cards can be a very expensive method of borrowing.
However, there is yet another way that we can build up interest on our credit card debt which is slightly more underhand and of which many people will be unaware. And worryingly, this can even affect those who have taken advantage of a 0% balance transfer deal. Essentially, this concerns the way in which interest is calculated on our credit card debt.
Which debt is paid first?
Readers of lovemoney.com who are currently getting out of debt will know that the most sensible method to tackle them is to pay off the most expensive debt first. After all, this is the one that's accruing interest the fastest - and increasing your debt!
Unfortunately, many credit card providers do not take this view. Instead, they choose to use your payments to pay off your cheapest debt first, often your promotional or low APR borrowings. This is known as negative payment hierarchy. As a result, your most expensive debt continues to accrue interest and means that you could be paying far more for your borrowing than you should be.
In fact, a recent study by Moneysupermarket has found that a debt of £3,500 could cost a cardholder an extra £200 in interest and take an extra two months to pay off if a card operating negative payment hierarchy is used, compared to one that pays off the most expensive debts first.
The tale of Tom
Let's assume Tom has a card with a negative payment hierarchy. He transfers over a balance of £2,000, spends a further £1,000 and withdraws £500 in cash, leaving him with a balance of £3,500 on the card. His card is currently offering 0% interest for six months for balance transfers so Tom feels happy that his £2,000 will earn no interest for this time. Additionally, the APR for new purchases is 14.9% and 16.7% for cash advances so Tom believes he knows how the interest for his £1,000 of new purchases and £500 cash withdrawal will be accrued.
Unfortunately for Tom, his monthly payments of £105 are being used to pay off his cheapest debt, namely his 0% balance transfer debt of £2,000, first. This of course means that the more expensive debts, namely the new purchases being charged at 14.9% and the cash withdrawal (being charged at 16.7% from the day Tom withdrew the money) are continuing to accrue interest in full and will not be attacked until his £2,000 balance transfer has been paid off in full. As a result, Tom will be paying nearly £841 in interest.
However, if Tom had chosen card like Nationwide BS Classic Visa, he would be in a different situation, simply because it operates a positive payment hierarchy - it chooses to pay off the most expensive debts first. His payments would be attacking his cash withdrawal and new purchase debts instead which would knock his interest bill down by a quarter, culminating in an interest bill of just £631, saving himself £210!
Similarly, the Halifax All in One Mastercard offers 0% on both balance transfers and purchases for nine months. Because the 0% offer is equal for both types of borrowing, you are free to spend on this card and transfer a balance, without having to worry about negative payment hierarchy.
Pick the right card
It's believed that just one in four credit card providers work on a positive payment hierarchy system, so you need to check the small print of any credit card, if you don't intend to pay off your balance in full each month. And if you have carried out a balance transfer to a negative payment hierarchy card, avoid accruing any interest by not using it for further spending (unless it also offers 0% for new purchases, too). Why not cut it up - and concentrate on clearing that balance before the 0% period expires, instead? And finally, we should all avoid using our credit cards for cash withdrawals as much as possible - the debt starts to accrue interest from the day it's withdrawn and is a hideously expensive way to obtain cash.
Used properly, there are many advantages to having a credit card - we just need to be careful that we don't let them take advantage of us!
Search and apply for a number of 0% balance transfer cards in our shiny new Credit Card Centre.