There are many different types of credit cards available, and they all work a bit differently! Here’s everything you need to know about credit cards so you can decide if getting one is right for you given your current lifestyle, future goals and budget.
What is a Credit Card and how do Credit Cards work?
- A Credit Card is flexible way to make purchases, streamline your finances and smooth out your cash flow. However – before you go ahead and sign up for a credit card, it’s important to be familiar with the different types of credit cards and how they work!
- Interest-Free Credit Cards – Interest free credit cards are a great starting point for those who are new to credit, giving you better control over how you borrow money. Interest free cards don’t charge interest – instead, you will pay a monthly fee depending on the card limit.
- Low-Fee Credit Cards – Low fee cards suit those who require a convenient way to borrow and spend, whilst being confident you can pay the balance in full at the end of every statement period (usually monthly).
- Low-Rate Credit Cards – Low-rate cards tend to have a lower interest rate than most other cards and are most suited to those who want to minimise the interest they pay, as a result of carrying a balance month-to-month (as opposed to paying a balance in full). These cards usually have a higher annual fee to compensate for the low ongoing interest rate.
- Award Cards – Award credit cards allow people to earn points for spending – some of the best rewards include earning points on travel, access to special deals and gifts, and even cash back.
How does credit card interest work?
- Even though credit seems to be created “out of thin air”, banks charge interest on the amount borrowed. Interest is the compensation lenders earn for the risk of lending money to borrowers. Typically, the better a person’s credit rating, the less risky they are to lend to, and the better the interest rate they are likely to receive. How much interest is paid also depends on the type of card, the transactions incurred, and when repayments are made. Different banks calculate interest differently – some calculate interest from the date of purchase, and some charge interest from the date that the interest-free period finishes. Interest usually compounds daily, and is charged until the balance of interest and principle, is paid in full.
What is a balance transfer? What is an introductory period?
- A balance transfer is exactly what it sounds like – it’s when a credit balance is transferred from an existing card, onto a new card with a new lender. Some cards offer an introductory period with a low interest rate – which can be a welcome sigh of relief when you’re struggling with compounding interest and late fees, and you just need a break. However – be careful with introductory periods! When the introductory rate finishes, the outstanding balance (and interest) will be treated as a “cash advance” (when you withdraw money from a credit card), then, a fee may be incurred, and interest charged at a high rate! And not to mention – some cards don’t allow for balance transfers or cash advances.
What kind of fees get charged on credit cards?
- There are various types of fees that can be charged on credit cards, including annual fees, monthly fees, late fees, and transaction fees. It’s imperative to budget for these fees as part of financing your credit card.
What is an interest free period on a credit card and how are interest-free periods calculated? What happens if you don’t repay your closing balance in full?
- An interest-free period is similar to an introductory period – it’s a period of time where you won’t pay interest on purchases. Provided you pay your closing balance by the due date, and pay your account to $0, you won’t pay any interest on purchases. Importantly, if you don’t pay the closing balance in full by the due date (i.e. you only make the minimum repayment, a partial repayment or you’re late altogether) – you will immediately start incurring interest from the due date onwards. If you’re late or pay less than the minimum repayment, you’ll probably get slammed with late fees, too.
How to avoid paying interest?
- To avoid paying interest, you need to pay your credit card balance out to $0 before the due date of your statement period.
Are there different types of interest?
- Most people know that principle is the actual amount of money borrowed – and interest is the additional amount that lenders are entitled to charge to compensate them for the risk of lending their hard-earned money. But what most people don’t know, is that there are seven different types of interest – fixed, variable, annual, prime, discounted, simple and compound interest.
- Fixed Interest Rates are exactly that – they are fixed throughout the course of the loan and are usually decided upon agreement between the lender and borrower, at the time of originating a loan. Fixed interest rates don’t fluctuate, so it gives all parties certainty as to the exact amount of interest that will be paid by the borrower and received by the lender.
- Variable Interest Rates fluctuate over time, dependant usually upon economic conditions. Variable interest rates are typically linked to the prime rate of interest (base rate) set by the Reserve Bank of Australia (RBA), which leaves borrowers “better off” if the base rate goes down – because this usually means the variable rate goes down too. On the flip side, if the base rate rises, so too does the borrower’s variable rate (meaning the borrower pays more interest).
- Annual Percentage Rate – An annual percentage rate is most often seen with credit cards or credit payments, where the annual interest rate is stated on the total cost of the loan, based on the total sum of interest pending. Annual rates usually get broken down based on a billing cycle and are expressed as a daily prime rate.
- Prime Interest Rates – Prime rates are typically lower than the average lending rate and are usually reserved for good customers with excellent credit ratings and good borrowing histories.
- Discounted Interest Rates – these rates are not available to the general public and are typically short-term rates offered by the Reserve Bank to the help Central Banks retain their lending capacity, maintain liquidity, or prevent the bank from failing during a crisis.
- Simple Interest Rates – Simple interest is the simplest way to calculate the interest charge on a loan, expressed as a fixed percentage of the principle.
- Compound Interest Rates – otherwise known as “interest on interest”, compound interest is the holy grail for investors, who will re-invest returns to make their money grow thanks to the power of compound interest.