Why it's important to pay off your credit card balance every month

It is a common misconception that interest is not incurred if you pay the minimum amount

Choose a card that does not have an annual fee or if it does, ensure the benefits it provides are more in value than the fee you pay. Photo: Alamy

Credit cards are the most common form of credit for average consumers, yet experience has shown me that most people don’t understand how they work.

It is understandable because the terms and conditions tend to be overly complicated and heavy with financial jargon.

It is not always possible for a non-financially trained person to understand the language, terms, mechanisms and true impact on their financial lives without first investing hours of confusion and frustration. It can be very difficult to find someone to help who does not have a vested interest in you signing up for that product or service.

First and foremost, the goal of credit card companies or banks that issue them is to earn interest from unpaid balances. Never forget that. The longer you leave the balance unpaid, the more they earn.

In my experience, providers clearly communicate your obligation to pay a minimum amount each month by a certain date. This is calculated as a percentage of the outstanding balance at the end of the month. If you don’t pay this amount on time, the bank will charge you a late payment fee. This is usually a set flat fee and is not dependent on the total amount you owe.

It’s a common misconception that you do not incur interest if you pay the minimum amount each month. This is not true. Many people have told me the credit card salesperson misled them on this point. You only avoid paying interest if you pay off the full balance each month.

Compounding happens when the bank charges you interest on interest. This happens when you do not pay off your card in full and so the bank adds an interest charge to your balance due.

If you do not pay your card balance off in full, the next month you are paying interest not only on the money you charged to the card but also on the interest from the previous month.

This is why many find their credit card balances growing out of control despite not using it.

One individual I worked with stopped using their credit card but paid only the minimum amount each month. After a year, she was frustrated to see her balance had actually increased. It was almost double what she spent originally.

So, how do you make a credit card work for you? Number one rule: always pay it off in full every month. If you do not have the cash to pay for your purchase, do not charge it to your credit card. Treat it the same as your debit card. If the money is not in your bank account, you cannot charge it to your credit card.

There are many credit cards available in every market. Choose a card that does not have an annual fee or if it does, ensure the benefits it provides are more in value than the fee you pay.

Find a card that provides benefits you will actually use. For example, my card is linked to my airline of choice. This means every time I use my credit card, I am accumulating air miles for my chosen airline. By doing this, I have accumulated enough miles to only pay taxes on my annual flights home every year. These benefits far outweigh the fee I pay the bank to have the card.

Be wary of cashback options. Read the fine print because while 10 per cent cashback on every purchase may sound great, there is almost always a cap if you read the fine print. Look for the asterisk beside the shiny offering. For instance, the lower of 10 per cent, or Dh25 per transaction, means you get Dh25 in cashback, not Dh100, on a Dh1,000 transaction.

Sometimes emergencies come up and if you don’t have an emergency fund, a credit card can be a convenient way to fund a sudden expense. Make paying it off as soon as possible a priority so you don’t end up paying multiple times for that emergency cost. But it is also important to learn the lesson and make saving for an emergency fund a financial priority.

Understand the difference between the monthly interest rate and the annual interest rate. Many credit card providers advertise their monthly rate, which can be misleading.

If your credit card's interest rate is 2.99 per cent, that sounds very low, right? Multiply that by 12 to get your annual percentage rate (APR) and suddenly a card with an interest rate of 35.88 per cent doesn’t sound so appealing.

The number one rule when you are tapping that credit card is to ensure sure you can pay off the balance at the end of the month. Otherwise, you not only can’t afford your purchase, but you will also end up paying much more than the cost shown on the cash register.

Carol Glynn is the founder of Conscious Finance Coaching