Credit cards are very popular financial products, and Canadians have an average of 2 credit cards each. There is something for everyone, such as cards with no annual fees, low interest rates, cash back, etc. In addition, cards can serve different purposes:
- A student credit card helps build a credit history. Often they have no annual fees. Credit limits are low, but sufficient for a student's expenses.
- Rewards cards let you earn points for rewards. In order to get the most out of this type of card, you must be able to pay off your balance each month.
- Cashback cards offer you a discount as a percentage of your purchases. This discount is generally between 0.5% and 4%.
- Low interest rate cards offer an interest rate significantly lower than traditional cards. They are often between 13% and 16%, while traditional cards are between 19% and 22%. If you’re unable to pay off your card balance each month, choose a low-rate card.
- Balance transfer cards are specifically designed to pay off another card. Usually, institutions offer a promotion for a limited time. For example, get a 0% rate for the first 180 days. If you have a debt that you’re unable to repay, it would be beneficial to transfer that balance to a balance transfer card and to take advantage of the promotional rate period.
- Credit cards to build your credit are used to rebuild your score after pitfalls in the past or to build your history (newcomers for example). The majority of these cards require a security deposit that often becomes the credit limit. To learn all about credit scores, check out this article. Learn ways to increase your rating.
Despite their differences, they all have an interest rate. But how does the interest rate on credit cards work?
What is a credit card interest rate?
The interest you see on card offers is expressed as an annual rate. This interest is charged only on the balance you owe at the end of the month. In other words, if you pay off your entire balance before the due date, you won't have to pay any interest. Conversely, if you are unable to pay off all of this balance, you will have to pay interest.
The same principle applies for cash advances and balance transfers. However, this interest is often at a higher rate compared to everyday purchases. If you withdraw from your credit card at the ATM, interest begins accumulating right away. There is therefore no grace period as there is for purchases.
There are rare credit cards offering a variable interest rate that changes according to the prime rate. In this case, it's called the premium. It represents the additional portion charged by your bank on the prime rate. If the prime rate increases, your interest rate also increases.
How the interest rate works
The interest rate you see on your statement is expressed as an annual rate. When interest is applied to your account, the institution will calculate interest based on the daily rate (per day). That is your annual interest rate, divided by 365. This daily rate will then be multiplied by your unpaid balance and added to your account on each day of your billing cycle.
You have a grace period, which is usually 21 days after receiving your monthly statement. After that, interest will be calculated from the date of the transaction.
For example, you buy a new refrigerator for $2000 (tax included) on May 1st with your credit card which has an annual interest rate of 19.99%. Suppose your card had a $0 balance before the purchase, so your account balance is now $2000. On May 31, your credit card issuer sends you your monthly statement, and you have a 21-day grace period to make the payment. Let's see what happens if you don't have the money in your account by the due date and you can only pay off the balance on July 1, which is 10 days later.
To find out how much interest you'll need to pay, let's first calculate the daily interest rate for your credit card.
An annual interest rate (19.99%) divided by 365 (number of days in a year) becomes a daily rate of 0.054,767%. Exactly 61 days have passed since your purchase, so 0.055 multiplied by 61 days is 3.34%. The purchase was for $2000 , so we multiply that amount by the 61-day interest rate (3.34%), and we get $66.80.
In short, your $2000 credit card purchase at 19.99% annual interest, which you pay in full 61 days after the transaction date, will have cost you $66.80 in interest. Your new refrigerator will then have cost a total of $2,066.80.
If, for example, you can only pay an amount of $1000 on that date. The bank will apply this amount to interest charges and other charges before applying it to the card balance. That is, you will now have an account balance of $1,066.80 and $0 in interest charges.
Should I pay off my credit card or invest my money?
You may have heard someone say that it’s better to invest your money than to pay off your debt. It was probably your brother-in-law who told you that.
It’s true that sometimes it’s better to invest. For example, if you have $35,000 to pay a downpayment on a property, but the minimum down payment required is $20,000, it is smarter to pay the minimum and invest the remaining $15,000. The reason is that in recent years, mortgage interest rates have been very low. So it’s better to invest your money at an interest rate of 5% (for example) than to take this money to pay off a debt of 2.95% (for example). In other words, if you are almost certain that the return on your investment will be greater than the interest on your debt, invest.
However, this is never (or almost never) the case with a credit card. Few investments will give you a return of 19.99% with near certainty (or even 12% for low interest cards). So, give priority to paying off your card.
The bottom line is, if you pay off your full credit card balance every month, get a credit card that maximizes rewards or cash back. Otherwise, get the card with the lowest possible interest rate. Be aware, however, that the best interest rates on the market are offered to those with excellent credit, as they present the lowest risk in terms of repaying their balances.
The best way to determine what rates you might qualify for is to find out your credit rating and look at the range of rates available for cards that require that level of credit. To do this, you can use a credit card comparison tool and enter your score. The comparison tool will find the best offers according to this information. If you want to learn more about how credit cards work, check out this article. Lastly, to test your general knowledge of credit cards, take this quiz.
This article was compiled by Hardbacon, which has designed a credit card comparator listing hundreds of Canadian credit cards. Hardbacon also helps you save on savings accounts, chequing accounts, online brokers, robo-advisors, life insurance, mortgages and personal loans. If you want to go one step further and take control of your finances, you should download Hardbacon’s mobile app, which links to your bank and investing accounts, helps you plan for your financial goals, create a budget and invest better.