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A beginner's guide to understanding how credit cards work

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Credit cards can be a useful financial tool - if they're used wisely. Understanding how they work can help you make the most of your card.

They are what bankers call a "revolving line of credit". This means you can continually re-use the credit on your card up to a predetermined credit limit.

So, unlike a personal loan, you don't have to re-apply for funding each time you make a purchase.

how credit cards work

Get to know your card's interest-free days

One of the downsides of credit cards is that they can come with high rates of interest - certainly well above home loan rates. But it's possible to avoid interest costs altogether.

Most cards come with an interest-free period - usually 44 to 55 days. If you're able to pay off card purchases within the interest-free period, credit cards can be virtually cost free, with annual fees being the only expense you may have to wear.

Minimising interest charges

As a revolving line of credit, your credit card lets you carry an ongoing balance from one month to the next. This will mean paying interest on the debt, but here too there are opportunities to minimise the cost.

Each monthly card statement will show the minimum repayment due that month. It's usually set at 1.5% to 2.5% of the card balance.

Sticking to the minimum payment will not only extend the time taken to clear the debt, it will also inflate your long-term interest bill - and, in turn, the cost of purchases made with the card.

So, it's very much in your interest (no pun intended) to pay more than the monthly minimum. There's no charge to pay extra, and every additional dollar helps whittle away the card balance, letting you save on interest .

Your monthly card statement shows how much you will pay in interest, and how long it will take to clear the slate, if you stick to the minimum repayments. It's a worth a look as it can be quite an eye-opener to see how interest charges can increase over time.

Cash advances

Life can dish up surprises, and there may be occasions when you need cash in an emergency. At times like this, your credit card can provide a financial lifeline through a cash advance. But it's a feature that should be used sparingly.

As a rule, cash advances do not come with interest-free days. The interest meter starts ticking from day one. So, it's important to pay off the advance as soon as possible - and only withdraw what you can afford to repay.

Choose the card that's right for you

Ultimately, the key to making the most of the features and flexibility of credit cards is to use them sensibly and know which type of card is right for you.

If you're likely to pay off your card in full before interest charges apply, a card with a low annual fee can be a good choice. If you're more likely to carry an ongoing debt, opting for a low-rate card can help you keep a lid on interest costs.

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A former Chartered Accountant, Nicola Field has been a regular contributor to Money for 20 years, and writes on personal finance issues for some of Australia's largest financial institutions. She is the author of Investing in Your Child's Future and Baby or Bust, and has collaborated with Paul Clitheroe on a variety of projects including radio scripts, newspaper columns, and several books.
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