There are generally two different arrangements for credit repayment: fixed and revolving.
Fixed repayment is where you have made an agreement with your bank to pay them a set amount of money each month until the total amount owing is paid in full. The loan amount is paid out at the beginning of the term and repayment amount is fixed with the outstanding amount being reduced with each payment made.
Revolving loans are set up differently. Generally credit is available – up to a specified limit – and your minimum payment will be based on the amount of credit used.
The minimum payment calculation will vary depending on the institution that issued the credit card, but it’s usually comprised of a fee plus interest. For example, the Royal Bank states on their website the minimum payment "will normally be $10 plus the interest and the fees.” You can review your credit card agreement or contact your bank to determine what this calculation is for your credit card.
In addition to the minimum payment fees, charged interest will accumulate on the credit card balance. There is a grace period – a number of days when no interest will be accrued – for new purchases; however, interest is always accruing on your old balance. No grace period is provided for cash advances on your credit card, so interest starts accruing immediately on these transactions – and often the interest rate for cash advances is higher than your purchase rate.
Lines of Credit
Usually the minimum payment on a line of credit is based on the interest only. There is no grace period with a line of credit and the interest starts accruing as soon as the line of credit is used. So interest starts with the very first purchase and continues building with each successive purchase. This holds true regardless of whether the line of credit is unsecured or secured, or whether it’s a student line of credit or home equity line of credit.
The payments set out in the statement for these credit facilities are minimum payments. As outlined above, these payments can be interest only or interest plus fees but note that these payments do not include a principal payment – so they do not reduce the total amount owing. That means that by paying the minimum payment you are deciding – perhaps unintentionally – to maintain this outstanding debt and pay interest on it indefinitely.
You need to be strategic about how you use credit and how you pay it down in order to minimize the interest and fees you are required to pay. Of course avoiding credit allows you to avoid these fees. But failing that, it’s good to consider:
Paying off your credit card each and every month;
Saving for big purchases instead of using credit;
Using your credit card for smaller purchases that can be paid off the very same month;
Using a line of credit – because it will have a considerably lower interest rate – for larger items that will take longer to pay off; and,
If you have an outstanding debt balance, paying more than the minimum payment and working toward eliminating the debt.
For more help understanding how credit impacts your bottom line, don’t hesitate to give us a call.
Rebecca Frederick, Frederick & Company Ltd.