A simple guide to credit cards

Money Advice Service

Used well, a credit card is a secure and flexible way to pay and can be a good way to spread the cost of major purchases. But if you only make minimum payments or run up a bill you can’t pay back, credit cards can be costly. Find out more about how credit cards work, and if they would be the best option for you.

How does a credit card work?

A credit card lets you spend money on credit – it’s like having a loan for the amount you spend using the card. You can spend up to a pre-set credit limit, which might be a few hundred or several thousands of pounds.

It depends on how confident your card provider is that you’ll pay it back.

If you pay off the bill in full each month, you won’t pay interest on what you’ve borrowed. If you make cash withdrawals though, interest is usually charged on a daily basis from the day you take your cash.

This is one of the reasons why you should avoid taking cash out using a credit card. You’ll be hit with charges – up to 4% or more with some companies. The interest rate for cash withdrawals is also usually higher than for purchases.

If you don’t pay off any outstanding balance in full then interest will be charged.

It’s usually backdated too, so if you bought something at the start of the month you’ll be charged a whole month’s interest.

Is a credit card for me?

Did you know?

Around 60% of people who have credit cards pay off the total balance each month.

Source: UK Cards Association

There are some important points you need to keep in mind before applying for and using a credit card.

  • You need to make at least the minimum payment each month, even during an interest-free period. Set up a Direct Debit for the full monthly balance, or for as much as you can afford to repay. This will mean you don’t miss a payment, which could lead to unwanted charges and the loss of any introductory rate. Missing payments could also damage your credit rating.
  • You’ll have a credit assessment by the card provider when you apply, which will usually include checking your credit reference file. A good credit rating will improve your chances of a successful credit application. It could also give you access to cards offering the lowest interest rates and/or promotional offers.
  • You need to be at least 18 to apply for a credit card. With some cards the minimum age is 21.

Pros of credit cards

  • Easy to carry, easy to use. Credit cards are accepted at more places than charge cards and prepaid cards.
  • Safer than cash. If your card is lost or stolen, just call your bank and cancel it. If it’s stolen and used fraudulently, you’re much more likely to get the money back.
  • Buy now, pay later. If you don’t have the cash you need until your next payday, or for a major purchase, a credit card gives you some extra financial wriggle room – though you should only use it if you’re confident you can pay it back.
  • You’re protected. With credit cards, you’re protected for most purchases over £100 and up to £30,000 – so if you book a holiday and the provider goes out of business, the card company should cover the cost even if you only paid an initial deposit by card. This is under Section 75 of the Consumer Credit Act. You might also be protected for smaller purchases that are under £100 with the ‘chargeback’ scheme. Read more about the protection you get with credit cards.
  • Freebies often come with credit cards – things like air miles, reward points and cashback. Find out more about Cashback credit cards.

Cons of credit cards

  • High-interest payments. If you don’t clear your balance at the end of each month you’ll normally have to pay interest on your outstanding balance. The interest rate on a credit card can be quite a bit higher than for a personal loan.
  • Beware the debt spiral. Miss just one payment and the interest will start to add up. Unless you pay off what’s owed each month, you can quickly spiral into debt if you continue spending on your card.
  • Additional fees. As well as the interest, you could find yourself paying additional fees or penalties for exceeding your credit limit or missing a payment. There are also fees for using a cash machine, and some cards charge an annual or monthly fee on top.
  • Deposits and pre-authorisations can cut into your credit limit. Some places like hotels or car rental firms might use your credit card to take a pre-authorisation. This is so they can charge you if you use things like the mini-bar and don’t pay for it. They’ll put a hold on part of your credit limit – say £500 – and while it’s in place you won’t be able to spend the money. Even after they remove the hold there might be a few days’ wait until your credit limit is back to normal.
  • Expensive to use abroad. This very much depends on the card. Some are designed for travellers, others are more expensive when it comes to fees and other charges – depending upon whether you use the card for purchases or cash withdrawals. Shop around to find the best deal.

Charges and fees

Be careful how you use your credit card. There are all kinds of ways you can incur charges.

Watch out for interest rates

If you don’t pay off your credit card balance at the end of the month, and you’re not in a 0% introductory period, you’ll pay interest on the whole of the statement balance, not just the part you haven’t repaid.

New customers beware! You might get an introductory rate when you first get the card. But check whether this covers purchases or balance transfers or both. Remember, it won’t cover cash withdrawals.

Also, check what the interest rate will be once the introductory period is over and make sure you repay in full before then if you can.

If you’re transferring a balance from another card, you will usually be charged a fee, often around 3%.

You need to work out whether it’s worth paying this in order to benefit from a lower interest rate on the card you’re transferring to.

Late payments damage your credit rating

If you make your payment after the monthly deadline on your statement, you’ll have to pay a late payment charge.

Any 0% or other introductory rate could also be withdrawn. On top of this, other companies will see that you were late, as part of your credit record.

This could have a negative impact on future credit applications like applying for a mortgage.

Minimum credit card payments can get out of control

When you get your credit card statement you can choose to pay off a minimum amount, the whole thing or any amount you choose.

Always aim to repay as much as you can – if you only make the minimum payment, it’ll take a long time to pay off your debt and you’ll end up paying a lot more than you borrowed.

Example

If you had a £1,000 balance, are charged 18% interest and no longer use the card:

Monthly repayment Total interest Total cost Time taken to clear balance
£30 £353 £1,353 3 years and 10 months
£100 £85 £1,085 11 months

By paying £70 more each month you’d pay £268 less in total and pay off your debt 2 years and 11 months earlier.

Cash withdrawals cost money

Credit and debit cards work differently at cash machines. Debit cards are mostly free or tell you if there’s a charge.

If you use your credit card you might pay a fee every time you take out cash and you might not be warned of the extra cost when you use the machine.

Fees can be as much as £5 per withdrawal. You’ll also be charged interest on the money, even if you pay it off by your card repayment date.

The same applies to other transactions that are treated as cash – such as using a credit card to purchase foreign currency or gift cards, or make gambling transactions.

With fees and interest, avoiding taking out cash on a credit card is the best advice.

Credit card cheques come with fees

A credit card cheque is like a normal cheque, but the money goes on your credit card bill instead of coming out of your bank account.

  • They are expensive – they are treated like a cash withdrawal, so the interest rate is higher and there are additional fees on top.
  • Credit card cheques don’t have the same protection for your purchases as card transactions, because Section 75 does not apply.

They’re much less popular now and you have to ask for them from your card provider. As with cash withdrawals, they’re very expensive to use and the best advice is to avoid them.

This article is provided by the Money Advice Service.

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