Three rules for paying off credit cards

Published by Mark King on 27 July 2015.
Last updated on 27 July 2015

Credit cards

Most banks and building societies have their own credit cards and they usually partner with either the Visa or MasterCard payment systems. But it is the bank or building society that sets the interest rate, and any fees, charges or rewards. And when you pay your bill, the money goes to the bank or building society, not Visa or MasterCard.

Using a credit card is a bit like taking out a loan. However, unlike a loan, where you get given the full sum upfront and agree to repay it over a certain period of time at a set interest rate, with a credit card you can spend up to an agreed amount over a virtually open-ended period as long as you make the minimum repayments each month.

A credit card charges you interest for the convenience of being able to spread payments over time. The minimum repayment each month is typically set at 5% of the amount you've spent on the card, or £5 - whichever is greater.

In 2012-13, the average interest rate - referred to as the 'annual percentage rate' (or APR) - on a credit card was 17.56%, meaning that for every £100 spent on a credit card, the lender made a £17.56 profit over a year (unless it was paid off in full), and that's before any charges for late payment were levied.

Interest-free periods

However, lots of credit cards now offer interest-free periods on purchases to compete for your custom and, as a result, the length of the 0% period is getting longer and longer. At the time of writing, the longest available was 20 months.

Interest-free purchase credit cards are a great way to spread payment for big-ticket items such as holidays or a new sofa because, as long as you stick to the minimum repayment each month and clear your debt by the end of the interest-free period, you won't spend a penny more than if you had bought the items outright to start with.

So what's in it for the bank? Well, not everyone repays what they owe on time and, at the end of the interest-free period, some customers who are unable to clear their balance end up having to pay interest. At this point the APR will typically jump to anything between 16% and 18%, and so the bank starts to make money.

To avoid this, however, cardholders could consider switching credit cards to a 0% balance transfer card.

A balance transfer lets you move an outstanding balance from one or more existing cards on to a new card charging less interest. Often, the deal will include an interest-free period on the balance, which can be as long as two years (or up to 34 months at the time of writing). Some cards will also come with an introductory interest-free period on new purchases too but these don't tend to last long – typically for three to six months.

It's important to bear in mind that most balance-transfer deals come with a handling fee – usually around 3% of the balance being transferred – for the convenience of moving your debt to a lower interest rate. So moving a £5,000 balance on to a balance transfer card charging a 3% handling fee will cost £150.

However, if you're paying a high amount of interest on your credit card spending, you could still be better off moving all your balances to a 0% balance-transfer card even after the fee is taken into account.

Take this example from credit card payment company MBNA: Mrs Smith has a balance of £1,000 outstanding on a store card that charges interest at 26%. She is making fixed monthly payments of £20. The next day she takes out a card offering 0% on balance transfers for 12 months, with a 3% handling fee. She transfers the balance from her store card to this, pays the £30 handling fee and continues to make monthly payments of £20. Twelve months later, she will have made a total saving of £216.22. Even taking into account the handling fee, she is substantially better off.

If you move multiple balances on to a balance-transfer card, another benefit is that you will have to deal with only one lender and arrange just one repayment each month.

But don't forget: whatever type of credit card you have, if you fall behind with your payments, then you're likely to incur charges and your credit record (a file of your credit history used by financial providers to assess your suitability for a loan) may be adversely affected. If you're worried you might forget to make a payment, you could set up a direct debit for the minimum repayment to be taken from your bank account every month.

Something else to bear in mind is that the APR advertised might not always be the rate you're offered when you apply for a credit card because lenders take your credit history into account. If you have a poor credit score, you might be offered a higher rate of interest.
Useful websites for comparing credit cards include:


Three rules for paying off credit cards

1. Always repay what you owe on the card charging the highest annual percentage rate (APR) – first. The longer the balance goes unpaid, the more it will cost you to eventually clear.

2. Transfer your balance - this means moving all your credit card balances to a card with a smaller APR. You can do this by taking out a balance-transfer deal.

Typically, you'll be able to transfer your outstanding credit card debt to a card that won't charge any interest at all on new balances for up to 24 months (or more in some cases) but you will be charged a fee of around 3% of the balance you want to transfer.

Don't ignore repayments - a debt of £1,000 on a credit card charging an APR of 17.56% (the average APR charged on credit cards for the year ending 31 July 2013 according to the Bank of England) would cost a borrower £14.63 in interest a month.

But if they were to switch it to a balance-transfer card deal where the balance would be interest-free for six months, even with a 3% fee they'd pay just £30 for the convenience of freezing it for six months - a saving of nearly £58 compared to the interest they would have been charged had they left the £1,000 balance sitting on the 17.56% APR card.

Use comparison websites to find the best balance-transfer credit card deals.

3. Set up a direct debit for at least the minimum repayment to make sure you never miss a payment - most credit card providers will charge you for late or missed payments and these can also adversely affect your credit score.


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