Thursday, January 17, 2013

Guide to Credit Cards

Credit cards offer a convenient way of borrowing and when used properly they can provide flexibility and a range of useful benefits for the cardholder.

However, with hundreds of different cards to choose from, how do you know which is right for you? This guide aims to guide you through the credit card maze and help you identify the deal that is most suitable for your needs.

  • How do credit cards work?
  • What are the advantages and disadvantages?
  • What type of card is best for me?
  • Is there anything to watch out for?
  • Will I be accepted for a credit card?
  • Further advice 

How do credit cards work? 

Credit cards offer a convenient and secure payment method as well as a flexible borrowing facility.

When you pay for something using a credit card, the provider is effectively lending you the money. Every month you receive a statement which details all the transactions made. You then have a certain amount of time to make a payment. If you repay the balance in full, no interest is charged. 

What are the advantages and disadvantages?

  • Free, short-term credit - as long as you always pay your balance in full by the due date shown on your statement.
  • Credit cards offer a safe and convenient way to pay for goods and services both in the UK and abroad, particularly if you are purchasing over the internet, phone or by mail order.
  • Purchase protection - under Section 75 of the 1974 Consumer Credit Act card issuers and retailers take joint responsibility for faulty purchases, If you pay for something with a credit card, valued between £100 and £30,000, that turns out to be faulty or which you do not receive because the company goes bust, you can claim a refund from the card provider.
  • Protection against fraud — if you are the innocent victim of fraud you will not be expected to pay if a criminal uses your card.
  • Incentives for using a card such as loyalty points and cash back, or payments to support a charity.
  • A truly global currency, as credit cards are accepted in virtually every country around the world.

  • You will incur interest if you are unable to repay your balance in full every month. Interest rates vary significantly so if you can’t afford to clear your debt you should look for a card that offers a competitive rate of interest.
  • The amount you can spend on a credit card is capped so you may not have access to as much money as you expected. Limits of between £300 and £500 are common for those who have never had access to credit before, while those with a good history who have shown that they use cards responsibly are likely to be offered a higher credit limit. That said, because of the credit crunch and rising levels of bad debt, providers are now more cautious about the amount they will lend. So even if you have a good track record with managing credit, you may be offered a significantly lower limit if you apply for a new card. 
 What type of card is best for me?

There are basically three ways of using a credit card: straightforward purchases, moving an outstanding debt over from another card (known as a balance transfer), and withdrawing money from a cash machine. Providers tend to charge a different rate of interest for each, and then implement a payment hierarchy whereby the cheapest debt is cleared first, leaving you accruing interest at the highest rate.

Say you took out a new credit card and transferred £1,000 over from another card, made a £500 purchase and withdrew £200 from an ATM. You can’t afford to clear the £1,700 in full at the end of the month, so instead you plan to repay £150 each month. However, rather than being charged interest at one rate, you are charged 5% for the transferred balance, 16% for the purchase and 25% on the cash withdrawal. The chances are, the provider will use the £150 you pay off each month, to clear the balance transfer first – the last debt to be repaid will be the £200 you withdrew from the cash machine, and that is the balance you are charged the highest rate of interest on.

Annual fees are still unusual, so the best way to avoid such tactics is to use a different credit card for each different purpose, that way you’ll get the most out of your credit card for the minimum cost. (One tip though, is never use a credit card for withdrawing cash – not only are the interest rates for cash withdrawals usually significantly higher than those for purchases and balance transfers but you also get no interest free period. Interest is levied from the day you make the withdrawal, so even if you pay off your balance in full at the end of the month, you will not be able to escape it.)

Comparing credit cards has become easier. Providers are now obliged to summarise their key product features such as interest charges and fees in an easy-to-understand format, known as a summary or “honesty” box. This will appear in all credit card marketing information.

To make things even easier, we’ve identified four common scenarios which should help you work out what type of card is best for your circumstances:

I always clear my balance in full:

If you often use your card for purchases but clear the balance in full each month, you avoid paying interest.

Most cards offer an interest-free period of up to 59 days from the date of the transaction, which gives you some breathing space before your payment is due. However, there are a few deals that do not offer any grace period even if you clear your debt in full each month, so watch out for these.

If you always pay off your credit card, the interest rate is irrelevant. Instead look for deal that will reward you for spending. A number of cards offer reward schemes either in the form of cashback, charitable donations or loyalty points. Some are more generous than others so go for the card that gives you the best return on your spend.

If you can afford to clear you balance in full each month, but have a tendency to forget, or be late, making your payment, then set up a direct debit. This is the easiest way to guarantee you’ll always pay off your debt on time and avoid a penalty charge.
I can never afford to repay the balance in full:

If you use your credit card but can’t afford to pay it off in full each month, go for a card with an introductory purchase offer or a low standard rate.

There are a number of deals which have interest-free introductory periods. These can be great for those who don’t clear their balance each month. However, once the interest free period ends, you will be charged the standard rate of interest which will probably be between 12 per cent and 20 per cent. You therefore need to make sure you have paid your debt off by that time, or make a balance transfer and move it to another card.

Some people don’t want the hassle of having to shop around for a new credit card every six to 12 months in which case a card with a low standard rate of interest is worth considering.

If you’ve built up a debt on an existing card, look to move it over to a product offering a low balance transfer rate. Plenty of cards have introductory offers on both purchases and balance transfers - often 0% for both. If you want a card for both purposes make sure the introductory periods end at the same time, otherwise you’ll be caught in the payment hierarchy trap mentioned above where the cheapest debt is cleared firs.

The other alternative is to have a card for each purpose – one for purchases and one for your balance transfer.

Click to compare cards with low purchase rates, introductory offers on purchases and balance transfers, all balance transfer cards.

I’ve got an outstanding debt I want to get rid of:

It is very easy to run up a debt on a credit card but paying it off can be much harder. UK card holders owed an average of £2,060 each in 2007, according to Apacs, the clearing service. Re-paying this amount of money can take years unless you are disciplined.

The first thing to do is make sure you pay off more than the minimum each month. Card providers insist you make a repayment every month but the amount you have to pay tend to be very low – often around 2% of the outstanding balance or £5, whichever is greater. If this is all you pay each month it could take years to clear your debt as you’ll be repaying little more than the monthly interest charges. In order to clear your debt as quickly as possible, you therefore need to work out the maximum you can afford to repay each month.

The other important thing to do is minimise the interest you pay. There are plenty of credit card deals offering interest free periods on balance transfers, so take advantage of one of these. You will have to pay a transfer fee of 2% to 3%, which will be added to your balance, but this is worth paying if you can avoid being charged a high rate of interest.

The best balance transfer offers last for at least 12 months. If possible aim to have your debt cleared within that time. If you cannot do that, make a note of when the introductory offer expires - you can then move your balance over to another 0% deal and continue to avoid interest charges.

If you think you’ll be slow to switch when the introductory period expires or don’t want the hassle of continually churning your debt, then a card with a low lifetime balance transfer rate could be your best bet.

Whichever card you choose remember that any new spend will incur interest at the standard rate and, in the majority of cases, will be cleared after any debt charged at the promotional rate. Click here to compare all balance transfer rates, including 0% deals.

I’m a regular traveller:

If you go abroad regularly, then you need a card that doesn’t levy overseas usage fees.

Credit cards can be a safe and convenient method of payment, particularly when you are abroad, but they can also be costly. Most providers levy overseas usage fees which can significantly bump of the costs of a foreign transaction. British consumers spend about £300m a year on foreign usage fees according to Nationwide building society.

Credit card exchange rates are based on the Visa and Mastercard wholesale rates, with a loading percentage usually added by the card issuers. This can vary from 0% to 3% depending on the credit card. The rate applied may also be different depending on where in the world you are – some providers levy higher charges in countries outside Europe.

When selecting a credit card for use abroad it is also worth looking at the other facilities on offer, such as the provision of a replacement card in the event of the loss or theft of your own. Extra benefits may include an international assistance package or insurance for flight delays, lost luggage and personal injury.

To make choosing a UK credit card for use abroad a little easier we have dedicated a comparison table to the cause.

Another option if you are a regular traveller, is to go for a prepaid card, This type of card is relatively new to the market but an increasing number of providers are offering them. They can be used in the same way as a credit or debit card, but the difference is that you have to load money onto them beforehand and they do not offer a credit facility – you can only spend what is on there.

The fees on prepaid cards can be significantly lower than those charged by many credit card providers so they may provide a more cost effective alternative. For more information read our Guide to prepaid cards or click here to go to our prepaid card comparison tool.

Is there anything to watch out for?

The unwary credit card user can be caught out by a range of fees and charges, so be careful. Fees to watch out for include late payments, exceeding your credit limit and returned payments (if your cheque bounces or a direct debit is declined). And common charges include fees for cash withdrawals, balance transfers and overseas transactions.

Many card providers use a system called risk-based pricing. This means the interest rate you are offered will depend on your credit history. Providers advertise a ‘typical’ annual percentage rate which is a rate of interest that must be offered to at least 66% of successful applicants, so 34% could be offered a different rate than they applied for. Those with the best credit scores are most likely to qualify for the advertised rate. If your credit history is less than perfect you may be offered a higher rate of interest.

As has already been mentioned the other major thing to watch out for is how payments are allocated. Most credit card providers use a payment hierarchy where the cheapest debt is paid off first. You should therefore only use your card for one purpose unless the same rate of interest is charged on balance transfers, purchases and cash withdrawals.

Will I be accepted for a credit card?

Card providers look at your credit history when deciding whether or not to lend to you. A good credit score is vitally important.

Late or missed credit card, loan or mortgage repayments have a serious impact on your credit score, so it is worth setting up direct debits to ensure your payments arrive on time.

There are steps you can take to improve your chances of having an application accepted. These include cancelling any cards you no longer use as they may inhibit your ability to get further credit in the future. Firms are increasingly looking at the total credit available to you, rather than just focusing on your outstanding debt. You also need to make sure you are on the electoral register at your current address.

You also need to be careful about which cards you apply for – the best deals are only available to those with the highest credit scores so there is no point in applying for a card you have no chance of getting. Every time you make an application for credit a ‘footprint’ is left on your credit file and this has a negative impact on your score.

Further advice

If you are unable to meet your monthly repayments and are struggling to repay your outstanding balance, contact your credit card issuer. The earlier you approach them, the more sympathetic they will be to your situation.

Alternatively, consider switching your card to one with lower rates and fees before you become too bogged down with your repayments but beware - if you leave it too long you may struggle to find another company that is willing to lend to you.

If you are refused a credit card and wish to make enquiries concerning your own credit file you can apply to the credit reference agency for your record. This will show your past repayment history, any County Court Judgments or defaults registered against you, electoral roll details and previous credit searches.

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