This article is by Paul Murphy, our VP and financial literacy expert with 15+ years of investment and banking industry experience.
If you’ve ever floated a balance on a credit card, you’ve likely asked yourself: how does credit card interest work in Canada?
The basics seem simple. You borrow money from the credit card company. If you don’t pay it back, you are charged monthly interest.
But there are many factors, especially if you are in credit card debt, which makes it very important to understand how credit card interest.
For example, what if you only pay half the balance back? How is the interest calculated then? Or, what about new purchases? Do they accumulate interest right away?
Most people don’t know that credit card companies actually charge interest on a daily, not monthly or yearly, basis. This compounds each day and you won’t touch the principle until you pay down the interest. And there begins the debt cycle.
I want to explain how credit card interest works in Canada. My hope is that you’ll see that it can be extremely dangerous to your financial future.
How credit card interest is calculated
The average rate of interest on credit card debt is approximately 19%, with many as high as 29.99%.
Interest is usually shown as an annual percentage rate and is a fee paid for borrowing money so you can spend money today to purchase things you would normally have to save for.
Credit cards have become an integral part of how we spend money and have become completely integrated with our day-day lives and have provided us with an extremely convenient way to spend money.
But they also have made credit readily available and created a culture of buy now and pay later.
Credit cards actually charge interest daily, not monthly
Most people don’t realize exactly how the compound interest on their credit card is calculated and credit card companies rely on that fact.
Compound interest basically means that interest charges are added to the principal borrowed so you are then paying interest on the interest and the debt very quickly grows.
Most people know what their credit cards APR (Annual Percentage Rate) is. The APR gives you the approximate percentage you will pay in interest over the course of one year. However, most credit cards compound interest on a daily basis.
Let’s look at an example as to how this impacts what you payback.
You have $5,000 on your credit card, and your APR is 19%.
This means the daily interest rate is 0.052% (19%/365 days).
Multiply $5,000 by 0.052% and you get $2.60. This means your interest is $2.60 on the first day. Doesn’t seem so bad you might say.
However on the second day, your balance is now $5002.60, so on the second day, you pay 0.052% on the new balance of $5002.60 and so on and so forth. You would keep paying interest on the interest until you had paid it off.
Now, it’s not all bad. Credit card companies allow you a ‘grace period’ during which you can pay back the borrowed amount with zero interest.
The grace period is set by the credit card provider and is usually between 21 days to 30 days.
Unfortunately, a lot of people using their credit cards do not have the financial capacity to pay the borrowed amount in full during the grace period and credit card companies rely on this.
What if you just make the minimum payments?
The minimum payment is the smallest amount you can pay each month without going into default and then potentially incurring a late fees or having a negative impact on your credit rating.
Your minimum payment is applied towards that month’s interest charges and then the remaining amount, which – will be very low if you are only making the minimum payment – is applied to the principal (the amount originally borrowed).
Making minimum payments will keep the card in good standing and help protect your credit rating but you will end up paying far more than the cost of your purchase.
Regulation has now made credit card companies add a warning to your credit card statement showing how long it will take you to pay off the balance if you make only minimum payments.
Take a look on your statement and you will be shocked!
They put a warning on cigarette packages because they are a serious danger to your health and in the same way they have added a warning on the credit card statements as they can be a serious danger to your financial well-being.
Should you use a cash advance to pay down credit card debt?
A cash advance is when you use your credit card to withdraw cash from the automatic bank machine or write a cheque the credit card company conveniently provided.
Obtaining cash from your credit card usually incurs a higher interest rate and there’s no grace period so the daily compounding interest begins immediately at the higher rate on the amount you have withdrawn.
So as a way to get out of debt, it’s not a good strategy.
Transferring your balance to a new card
You have seen and no doubt been tempted to get a new credit card with a lower introductory rate if you transfer your current credit card balance.
This certainly could work for you if you have a plan and the discipline to not increase the balance on the new card, cut up or stop using the card you have just transferred the balance from and aggressively pay down the amount owed versus making the minimum monthly payment.
The first thing to check before transferring the balance is the length of time the low-interest introductory offer lasts and if you think you can realistically pay down the majority of the debt during that period.
Then you need to understand what the rate will be when the introductory offer is over and estimate what your balance will be at that time.
The standard rate on the new card may be greater than the old card and ultimately cost more in the long run…plus you need to confirm if there are any transfer fees or additional costs.
Remember, if you use the new card, new purchases made will be charged at the standard interest rate as the introductory rate is only for balance transfers. Any payments you make will be applied to the amount transferred not the new purchases.
Did I miss anything? Any other questions about how credit card interest works in Canada? Leave your question in the comment section and I’ll respond.
Forewarned is forearmed!
Other resources to help you:
Get a professional assessment of your debt situation
Your job is to educate yourself. If you are carrying a large amount of debt, speak to a professional.
You can find experts by searching in your city. We also have offices across Canada, which you can talk to on the phone, email, or meet in-person.
What does an expert know that you don’t? They will teach you about debt restructuring options such as debt consolidation, consumer proposals, informal proposals, and how to approach your creditors with a restructuring offer.
They will also be able to analyze the type of debt you carry and educate you on the right choice for you. You can sometimes reduce your debt with restructuring. For others, bankruptcy might be the right choice.
Here’s a list of our offices in your city.
- Barrie office
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- North Vancouver
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- Vancouver office
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- Victoria office (Langford)
- Victoria office (downtown)
And finally, here are real stories about debt from Canadians who survived their financial crisis.
A stern word from our lawyers . . .
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