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Money matters to secure your financial future.

4b. Credit

Est. read time: 3 min

Cash vs Credit

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When you don't have enough money to pay all your expense, one thing you can also do is use credit. A simple way of understanding cash vs credit is thinking of cash as the money you have, and credit as the money you borrow.

While having access to extra money through credit (credit card or loan) can be very tempting, remember – because it isn't your money it may end up costing you more than saving the necessary amount and paying in cash.

Compound Interest

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Compound interest works on savings and debt.  If you save $100 with a 10% savings rate, after one year you have $110. Compound interest is earned when you leave the $110 invested instead of starting again with $100 – as the 10% is then earned on the higher amount.

Compound interest for debt is interest that accrues on your debt, plus any interest you already owe – in other words you will be getting charged interest on interest. For example: let's say you owe $5,000 and your credit card interest is 2% per month:

  • In the first month, you will incur an interest charge of $100. That means by the end of that first month you will owe the credit card company $5,100;
  • If you make no repayments, next month your interest will be charged on the new amount owing of $5,100 and will be $102 which means at the end of month 2, you will owe $5,202;
  • This will continue so that by the end of 12 months, you will owe $6,341.21 and after 5 years, your initial debt of $5,000 will have grown to $16,405.15

Credit Cards

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Credit cards are not free money. All credit cards will charge you interest if you don't pay the balance off in full, and some will charge you a fee every year just for having the card. Credit cards are a very expensive type of debt – typically the rates of interest charged are very high.

A credit card statement will show you two options when you receive it: pay the balance in full or pay the minimum (usually a % of the balance), and this is where people get into trouble. If you only pay the minimum, not only will you accrue interest on the remainder (compound interest), but it will take you much longer to pay it off.

Personal Loans

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Personal loans operate in a similar way to credit cards. The main difference is that you are provided with a lump sum upfront. Personal loans can be secured, which means you offer something as security (such as a car) that the bank may take if you don’t pay.

Personal loans can also be unsecured, where no security is offered. Secured personal loans generally have a lower interest rate.

Personal loans can be fixed rate (repayments are the same for the life of the loan), or variable (repayment amount will change with interest rate changes).

Personal loans generally have an application fee and a monthly account keeping fee. Personal loans have many of the same challenges of credit cards, as you will generally pay a large amount of interest over the life of the loan. You can use the MoneySmart Personal Loan calculator to find out exactly how much.

Payday Lending

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Try to avoid what is known as ‘payday lending'. These are advertised as “quick, easy” loans that will have the money to you “in just hours”. They are advertised as a great way to get money when unexpected expenses crop up. In reality these loans charge extremely high interest rates and can cost more than you expect. Borrowing just $500 for a month may cost you $120 in fees and charges!

There are strict criteria payday lenders have to follow when lending you money.  Further information on payday loans can be found on the Consumer Credit Legal Service webpage.

Buy Now, Pay Later

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Advertised as interest-free finance or ‘buy now, pay later’ services, providers such as Afterpay, Zippay, Humm, and LatitudePay allow you to purchase now and pay later through equal, regular instalments (usually, every 2 weeks or monthly, depending on the provider), and payments are automatically deducted from your chosen card or bank account.  Whilst these buy now, pay later schemes might seem attractive to help you out of a tight spot, be aware that even though they don’t charge interest:

  • If a payment is unable to be processed on or before the due date, late fees may apply;
  • Some providers charge processing and/or monthly account fees;
  • If you use a credit card as your payment method, any unpaid amounts on your credit card after the due date will attract interest.

It can be easy to take out multiple ‘buy now, pay later’ services and get stuck in a spiral of trying to pay them all, or use one to free up money to pay another.

‘Buy now, pay later’ services are not currently government regulated, like credit cards and personal loans, so it may be harder to get help if you are having trouble paying. Speak to a financial counsellor if you need help.

Alternatives to Expensive Debt

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More information on managing your debts can be found at 4e. What to do when your debts are out of control and the MoneySmart website.

[Article last updated:  1/12/21]

 

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