4C. Credit alternatives

If you think of cash as the money you have, then credit is the money you borrow. Credit cards or loans can be an alternative way to pay for expenses. Remember – credit options may cost you more than saving the necessary amount.

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 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 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 incur an interest charge of $100, meaning you 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 are not free money. All credit cards will charge you interest if you don’t pay the balance in full, and some will charge you a fee for just having the card. Credit cards are a very expensive type of debt – typically, the interest rates 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, you will not only accrue interest on the remainder (compound interest), but it will also take you much longer to pay off your debt.

Personal loans operate in a similar way to credit cards. The main difference is that with a personal loan you are provided with a lump sum upfront.

There are several types of personal loans:

• Secured, which means you offer something as security (such as a car) that the bank may take away if you don’t pay back the loan. Secured personal loans generally have a lower interest rate.
• Unsecured, where no security is offered. These loans generally have a higher interest rate.
• Fixed rate, where the repayment amount is the same for the life of the loan
• Variable rate, where the repayment amount changes with the interest rate

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

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. For example, borrowing just $500 for a month may cost you $120 in fees and charges.

There are strict criteria payday lenders must follow when lending you money. For further information on payday loans, see Consumer Credit Legal Service webpage.

Interest-free finance or ‘buy now, pay later’ services such as Afterpay, Zippay, Humm, and LatitudePay allow you to purchase now and pay later through equal, regular instalments deducted from your chosen debit/credit card or bank account. Even though they are advertised as ‘interest-free’, extra charges may apply, such as:

• late or failed payment fees
• processing and/or monthly account fees
• 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 off 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 are), so it may be harder to get help if you are having trouble paying them off. For support, speak to a financial counsellor.

• negotiate with your provider, they may be able to offer payment plans
• consider a No Interest Loan, see Rebuild 3D
• Assess (or start) your budget – for further information on budgeting, see Thrive 4A
• Grants are available to assist with living costs – for further information on financial assistance for living costs, see Rebuild 3D
• For further information on managing your debt, see Rebuild 4D
• For further resources, see MoneySmart