Guest Blog Post by Ashley Dull, Editor-in-Chief of CardRates.com
Although few people would likely compare personal finance to their favourite sport, the two things have one important commonality: you need to know the lingo to understand what’s going on. In fact, if you use a credit card it is your responsibility to understand not only the jargon, but the terms and conditions as well.
Think how confused you’d be at a hockey game if you think “cake” when you hear “icing.” Similarly, if you think “cookies” when you hear “chip,” you may have trouble at a credit card machine that uses EMV-chip security.
While not knowing the jargon at a sporting event will simply result in a long couple of hours, not knowing important financial terms may lead to unnecessary fees and missed opportunities. This can be particularly true when it comes to products as ubiquitous as credit cards, which many people use every day without fully understanding important terminology.
Annual Percentage Rate (APR)
One of the most common acronyms in consumer finance, the annual percentage rate — or APR — refers to the effective annual interest rate charged by a credit product with compound interest, like credit cards. For some credit products your APR is based on your credit profile, for others the APR is set and only changes if you don’t manage your account as agreed.
Unlike a nominal interest rate, which is generally a simple interest rate based on the principal amount — e.g. borrowing $100 at 5% means you repay $105 total — credit card APRs represent the effective interest. That’s because credit cards use compound interest, which determines how much interest you pay based on your principal and accumulated unpaid interest each time it compounds.
So, while credit cards only charge you interest once a month, they actually calculate and compound that interest every day. This makes the steps to calculate your credit card interest a bit more complicated (see Canadian explanation about credit card interest and fees). Essentially, you need to divide your APR by 365 to get your daily interest rate, then use that rate to determine how much interest you pay on each day of the billing cycle. Your credit card statement will also tell you what your daily interest rate is. Add how much interest you pay to your overall amount owing for an estimate of what you’ll be charged.
And APRs get more complicated as you explore. For one thing, your credit card may charge different rates based on the type of transaction; balance transfers and cash advances have their own distinct APRs. Additionally, some APRs are variable, which means they can increase or decrease according to the Prime rate that banks set based on the Bank of Canada’s interest rate (or the US Prime Rate, for US-issued cards).
If all that interest talk has you wishing you could avoid the whole mess — good news! You can avoid interest charges with most credit cards if you know about the interest-free grace period.
The period of time between when your statement cycle closes and your due date, that is the grace period, and it typically lasts a minimum of 21 days. If you pay off your full balance during the grace period (i.e., before your due date), then you won’t be charged interest on those purchases.
There are two main things to note about credit card grace periods. First, you need to pay your balance in full to avoid interest charges; otherwise, you’ll be charged interest on all purchases and fees from that statement until it’s paid in full.
Second, the interest free grace period only applies to new purchases. Other transaction types, such as balance transfers or cash advances, do not qualify for the grace period and will begin to accrue interest as soon as they post to your account.
To take full advantage of the interest free grace period and never pay interest on your credit card purchases, pay your card off in full by the due date every month.
As credit cards become increasingly popular around the world, credit card issuers are finding new and better ways to try and attract customers (and to beat out their competitors). Enter: the sign-up bonus. Sometimes called a welcome gift, sign-up bonuses are lump-sum bonus rewards offered to new cardholders when they are first approved for a particular credit card.
Often worth hundreds of dollars in cash back, points, or miles, sign-up bonuses can be extremely lucrative to earn — but that’s the catch: you generally have to earn them. Most credit cards that offer a sign-up or welcome bonus will set a minimum spending requirement that must be met within a set period of time to earn the bonus.
For example, a cash back credit card might offer a bonus of $100 for new cardholders who spend $1,000 on their new credit card within the first 90 days of opening the account. If you fail to meet the spending requirement in the allotted time, you forfeit the sign-up bonus.
Of course, as lucrative as sign-up bonuses can be, it’s important not to spend more than you can repay simply to earn a bonus. In most cases, the interest you’ll be charged on a balance carried from month to month will quickly outpace your sign-up bonus, and accumulating debt can cause a host of additional issues beyond interest and fees.
Foreign Transaction Fee
Perhaps one of the biggest pitfalls of international commerce is the constant need to change currencies, especially since the procedure is rarely free. Whether you’re buying something online from a foreign retailer or traveling abroad on vacation, if your purchase isn’t in your home currency — it’s probably going to cost you.
While using a credit card for your purchase can help you override unfavourable merchant exchange rates (and the inconvenience of doing the math yourself), most credit cards in Canada charge a foreign transaction fee of 2.5% (US cards can be up to 4%) to make a currency exchange, which can easily add up over many purchases.
The easiest way to avoid paying foreign transaction fees with your credit card is to use a card that doesn’t charge them. These are often travel rewards credit cards deliberately designed to be useful — and economical — while you travel and vacation. Just watch out, as many of the best travel rewards credit cards will charge annual fees.
Understanding How Credit Cards Work and Not Getting Into Debt
Credit cards can be a useful tool, and just like any tool, when they are used wisely they can make your life easier. Understanding how interest is charged, how the Annual Percentage Rate (APR) is used to calculate daily interest, how sign up bonuses work, and the true cost of foreign transaction fees is all part of understanding the terms and conditions. Fully appreciating the benefits of the interest free grace period can also help you plan your pay cheques and balance your household budget more effectively. It is up to you to decide if the little piece of plastic is your flexible friend or foe!