How a credit card works

BANKS that dish out three-inch demons of flexible fun – credit cards – rely on people living beyond their means and clocking up debt on which they pay huge amounts of interest. Do you know, though, how your flexible friend really works?

Rickson D’Souza, director of wealth management at Pinnacle, a UAE-based insurance broker and wealth management consultancy, says: “We meet about 18 new people a week to talk about their personal finance situation. I would say about 60-70% of them are struggling with credit card debts – and many are unaware how their cards actually work.”

Although only 22% of consumers in Saudi Arabia pay by credit card and 78% use debit cards or pre-paid credit cards to avoid clocking up debt, 52% of 18-24-year-olds in the Kingdom are struggling with credit card debt, according to a recent Burson-Marsteller survey.

In the UAE, the figures are virtually reversed: credit cards account for 71% of card-based purchases and 29% of consumers pay at the time of purchase.

Hefty interest rates

Borrowing on credit in the Arab world can come at huge cost. Providers charge monthly interest rates, with the annual equivalent often approaching 35%.

Exorbitant interest rates in the GCC countries have been blamed on low credit ratings and the risk of losing money from bad loans.

However, in many parts of the Gulf region, the interest rates charged on credit cards do not reflect the borrowers' credit profiles. This is because there has been no serious move to establish a regional credit bureau to establish credit ratings for individuals, which would be used to set interest rates based on their creditworthiness.

Islamic banks do not charge interest: under Sharia law, interest cannot be charged and a monthly management fee is charged instead. This can be more transparent, but will clearly wind up more expensive if you do not carry a balance on the card at the end of each billing period.

Of course, if you overspend – and many of us do – you could soon find yourself struggling to repay the balance in full.

If you spend on credit, you must repay a minimum amount towards your balance each month (generally 5% of what you owe), and can pay the rest off over time. Interest is charged on any outstanding balance.

So, if you only pay the minimum, the amount going towards your debt is very small, with the majority going towards interest charges.

Sneaky tricks that cost you more

Moreover, do you know that the rate of interest you are charged can vary or how your repayments are assigned to your debt? Often higher rates of interest are charged on the likes of cash withdrawals, and when payment is made at the end of the billing period, card issuers generally apply this repayment to the part of the balance that has the lowest rate.

Sandi Saksena, a Dubai-based financial planner and member of Million Dollar Round Table, tells cashy: “Many people use balance transfer cards with low introductory interest rates, then put additional purchases or withdraw cash on the card not fully understanding that higher rates generally apply.

“Simply put, if you transfer a balance, purchase something, or withdraw cash, they are charged at different interest rates: a typical balance transfer card will charge 0% or a very low interest rate for an introductory period, a higher interest rate on new purchases, and a higher rate still on cash advances.

“When payment is made at the end of the month, the card issuer generally applies the payment received to the part of the balance which has the lowest rate, thus leaving the most expensive debt to accrue more interest. This is known as an adverse order of payments and costs the consumer in extra interest fees.”

cashy's top tips

Here are cashy’s top tips to getting your debt to work for you – not your bank:

Manage your debts

If you have debt, take out a balance transfer offer, then cut up the card so you are not tempted to use it.

“When offers are taken they should be used to transfer debt and pay down the balance,” says Saksena. “It's in your  best interest  to use the transfer card to pay down the balance without adding to it with additional spending, with an aim of clearing the debt before the introductory period ends and the variable rate of interest comes into effect.

Plan in advance

Budget a few months in advance for that plasma screen or dream holiday. If you buy now without having savings set aside to meet the cost, you’re sure to pay later.

Live within your means

Once you're back in the black, use a credit card like a debit card – if you must have one at all. Spend what you know you can afford from your monthly income and set up a standing order to repay the balance in full each month.

Hunt down a good deal

Some credit cards will give you a percentage of what you spend on your card back in cash. However, D’Souza warns that this is only worthwhile if you are repaying the balance in full, otherwise the charges and fees will cancel out the free cash.

Spend wisely on holiday

“Credit cards are good to use when travelling from a convenience point of view – and if you have a card that gives you Skywards [air miles] points or cash back, it can actually be earning you money,” adds D’Souza. “Sometimes you can lose money on the currency conversion when using a credit card abroad, but cashback can balance this out.”

Use personal loans

Credit cards are the second most expensive way of borrowing money – second to loan sharks, says D’Souza.

He says: “Interest on credit cards is usually 2.5-2.9% per month, which works out at 30-34.8% per year, whereas the annual interest on personal loans is normally about 11-12%. If you have a large payment to make, take out a loan.”

To compare credit cards, use cashy’s comparison table.

Pic credit: graur razvan ionut/ FreeDigitalPhotos.net

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Additional reporting by Inga Stevens