Interest on a credit card is charged differently depending on the type of transaction on the card. Maybe you made a new purchase. Maybe you’re carrying a balance from last month, which would be a “previous purchase.” Perhaps you took a cash advance. Or maybe, in an attempt to get your interest costs down, you did a balance transfer.

New purchases usually don’t attract any interest unless there’s a previous balance on the card or you end up paying after the due date. At that point, the interest clock clicks on back to the date of the purchase. No grace period! If you carry so much as a penny as a balance, then instead of getting a free ride from the date of purchase through to the date owed the following month, the interest clock clicks on back to the minute you did the transaction.

The interest-free or “grace” period never applies to cash advances. Yup, the minute you pull that money off your card, the clock clicks on and you start paying interest, usually on your entire balance. Ditto balance transfers unless you have a special deal going.

The interest you’ll pay is calculated in one of two ways:

• using the “average daily balance method” or
• using the “daily balance method”.

While these calculations are different, they often yield much the same results.  If you don’t much care, skip the next two paragraphs. If you really want to know the difference… well… here ya go:

Credit cards calculate the average daily balance by adding up the balance at the end of each day and then dividing the total by the number of days in the billing period. The answer is then multiplied by the daily interest rate (the annual interest rate divided by 365). They multiply the result by the number of days in the billing period (30 in June, 31 in July).

The daily balance method calculates interest owed at the end of each day. They multiply the daily balance by the daily interest rate, adding up the daily interest charges to obtain the amount of interest charged for the month.

Everybody back?

Credit card companies use one of two methods to decide whether the interest-free period applies to your new purchases. On some cards, the interest-free period applies to your new purchases if you pay your current month’s balance in full by the due date. This can be called “method 1” or “one cycle billing”. But some credit cards want to penalize you when you carry a balance even for one month. In an interest rate grab, “method 2” or the “two cycle” billing was born.  With this method, the interest-free period applies to your new purchases only if you pay your current month’s balance in full, by the due date, AND you did not carrying a balance from the previous month.

I find it interesting that in all the chatter about cardholder rights and changes proposed to protect consumers, two-cycle billing never saw the light of day.  And where is the protection for people – students in particular – who are offered credit with no visible means of repayment? And don’t get me started on over-limit fees or any of the other rapacious fees credit card companies pull out when they need to compensate for all the bad lending they did.

Credit cards can also charge a different interest rate for things like introductory offers, cash advances or balance transfers. Since those rates are often calculated in a different ways than the rates charged for purchases, you need to be careful when you use your cards.

Often, for example, if you do a balance transfer, you should NOT use that card for any additional purchases. Why? Well, while the balance transfer offer may seem like a gift, the new purchases interest rate can be through the roof. And since all your payments will go to the “balance transfer” pot first, your “new purchases” pot will continue to accumulate at that much higher interest rate.

The recent plans to try to protect consumers from the big bad credit card wolves does address this issue, but nothing has been cast in stone yet. So sometime in the future consumer payments may have to be assigned to the balance with the higher rate, or they may be spread between the two or more pots based on the relative size of the balance, but who knows.

While it may feel like torture to read your credit card agreement, if you don’t you’re walking blind into something that may bite you in the butt down the road. And whenever your credit card company sends out a notification that your terms and conditions have changed, pay attention.

It was a lack of attention that allowed the Method 2 calculation or “two-cycle billing”, which was born in the U.S. where credit card companies regularly stick it to their customers, to take hold in Canada. If more people had had their heads up and rebelled, our lenders would never have kept this option. Now it has a strong foothold, it would take a tsunami of customer cancellations to have it reversed. That’s ground we’ve lost as consumers that we’ll never regain.

3. Do you HAVE to bail them out? Sometimes you do. After all, they’re learning and some mistakes are too big. But kids need to learn from their mistakes. If you are always rescuing them whenever they get into a bind, they’ll never have to take responsibility for their own decisions. Going a couple of days on soup and crackers will help them see that spending all your money drinking on the weekend or buying that new pair of shoes has it’s ramifications. Heaps of kids have been taught that their mistakes are mommy’s and daddy’s to fix because, well, mommy and daddy can’t stand to watch Lil Suzie suffer.  Hmm.  You need to let your kids make their own mistakes and come up with their own solutions if you want them to learn that they can. No matter how painful it may be for them and for you, let ‘em sweat some.

4. Has your kid got impulse control issues? I’ve met many adults who can’t keep the impulse monkey off their back. Kids are particularly susceptible, especially if you’ve given into their every whim while they lived at home.  But at some point they have to learn to keep their impulses under control when it comes to their money. Have you taught your young’un to stop and think before spending money. Have you discussed things like emergency funds and how useful they can be for hauling your butt out of the fire when things go very, very wrong? Have you shared your own mistakes and how you learned about being prepared for the worst?

5. Is your child going to apply for and use a credit card at school? Credit cards get students in more financial trouble than anything else. Credit card companies target students in certain programs because they know their income potential and they want to grab ‘em by the short-and-curlies early on.  It’s a travesty. After all, when else can a person without an income qualify for credit?

Make sure you explain how credit cards work, the implications of taking cash advances (they shouldn’t, not EVER, because of the immediate interest hit), and how to track their spending on their card so they don’t end up with a bill bigger than they can afford to repay. Stress how what they choose to do now can affect them in the future. If you plan to co-sign a card ensure the limit is very low until you are sure your child has the good sense to deal with the responsibility of a credit card.

Tomorrow — Part 3: the cost of student loans and banking

Part 1: cash flow management

p.s. Thank you, Poetic Justice, for pointing out the typo in the title of the first part. Turns out all the titles would have been wrong. Good eye. Keep looking!

Have you ever wondered if HOW you pay for something affects HOW MUCH you’re willing to spend? Is it harder to part with cash than to slide your credit card through the machine? Do a $200 pair of shoes give you pause to think if you’re spending cash more so than if you’re putting it on your credit card?

You betcha!

A study in The Journal of Experimental Psychology says that shopping with cash discourages spending while using credit or gift cards actually encourages it. Fittingly called “Monopoly Money”, the authors of the study – Priya Raghubir from New York University ande Joydeep Srivastava from the University of Maryland — say, “…using a less transparent form of payment such as a credit card or a gift card lowers the vividness with which one feels that one is parting with real money, thereby encouraging spending…”

This is one of the big benefits of using the Magic Jars to keep your spending on track. Because you’re dealing in cold, hard cash, you’re more likely to weigh your priorities carefully, especially when you are thinking of buying something that isn’t essential. As the authors say in their study, “The outflow of money is very vivid when individuals use cash making it painful to part with …cash payments are more likely to be used for justifiable necessities and less likely to be used for frivolous luxuries which may accentuate the pain of paying.”

Add the fact that the Magic Jars make is very clear when you’re getting to the end of the money and suddenly Needs become far more important than Wants.

Such a simple idea: being able to see when the money is coming to an end. So why is it that if we know we need to live within our means, and we know that money runs out, we are so willing to waste it?

If everyone has access to free banking (not everyone does, I know), why does anyone pay for banking transactions? If everyone can get from point A to point B in a car that costs just $160 a month, why does anyone plunk down $549 a month in car payments? And if a $40 pair of shoes will do the job, why are we willing to spend $240 on a pair of shoes?

If you did not have access to credit of any kind — no credit cards, no line of credit, no over-draft protection, no loans – would you be as willing to drop gobs of your hard earned money on things like expensive shoes and fancy cars? Or is it the fact that you can defer feeling the pain of payment that lets you convince yourself that you Need that shiny truck with the whopping monthly payment?

I’ve worked with a lot of people who cry about how much debt they have. They sigh despondently when’s they consider that they may never shake free of the burden. They cringe when they think about how much interest they’re paying every year. (Sure, $200 a month may seem like not too much, but that’s $2,400 you could have put in your retirement savings plan, so don’t tell me you don’t have any money!)

Those same people are quite willing to buy a new snappy pair of pants, a lovely set of dessert dishes, or their 37^th pair of shoes. Whazzup with that? Why has consumption become the main way we feel better about our lives?

No doubt the deferral of payment has a big part to play in desensitizing us to the pain of payment. If we can have dinner out with friends tonight, and not have to deal with the idea of paying the bill until two weeks Tuesday, it’s easy to swipe the card. And that’s why, if you’re going to use credit in any form, you need to be tracking your spending as you spend. It’s the ONLY way to keep you in the moment and create a sense of real cost when you use credit.

All you need is a notebook and pen. Put your balance at the top of the first page and then track every cent you spend manually so you always know exactly how much money is in your account. Whether you use a debit card or a credit card, deduct the amount you’ve spent from your balance so you’re feeling the “pain” of having spent the money and you’re not tempted to spend the same money twice.

Yes, keeping track of what you’re spending takes a little getting used to. But it’s well worth it to keep your accounts in balance and your impulses in check. Just think about how much time you spend earning your income. Shouldn’t an equal amount of time be spent in considering and tracking how you spend it?

Funny Money: When was the first credit card made, and who made it?

The first time most kids learn about credit is when they go off to university and the credit card companies start throwing cards at them. Hmmm. With no experience and very little understanding of the long-term negative ramifications, kids start to charge. And they charge, charge, charge until they’re in a hole. Did you ever take the time when you were using your credit card to purchase gas or pay for a new bathing suit to explain how credit cards worked? Did you take the time to show your children that you’re only putting on the card what you can afford to pay for when the bill arrives? Probably not.

Even relatively young kids can get in on this lesson. Issue your 10-year-old a credit card on The Bank of Mom & Dad. (Have her design it herself, if you like.) Draw up a cardholder’s agreement that both of you sign. Set a really low credit limit ($10 is lots), and a deadline for paying it off before interest charges apply.

Your child can now use her credit card when she goes shopping with you. If she sees something she wants to buy, she gives you her card and you make the purchase on her behalf using your money. You give her a charge receipt. Remind her that she’ll have to save her allowance (or babysitting money) to pay the bill when it arrives.

If she spends more than she can afford, or makes her payments late, you’ll have to charge her interest on the balance. Use 25 percent as your interest rate for this exercise, and don’t give in. When she sees that the $10 item actually costs $20 over the long run, she’ll know that credit cards should be used with caution.

Once you’re child is sixteen or so (you’ll have to gage his maturity), you should get him an actual credit card (it may be in your name) and start him using it and repaying it regularly. This is a habit, and one well worth the effort to form.

Don’t skip steps because you think they should be obvious to your teenager. Start by explaining how credit cards work. Emphasize the connection between charging one month and paying the next. Stress that credit is not “free money” unless the balance is paid in full before the grace period expires. Explain interest and how it compounds if a debt piles up. Read the fine print and review key terms such as late fees and over-balance charges. Talk about how to keep the card safe, and what to do if it’s stolen or lost.

Set limits and monitor your child’s use of the card. They must prove their ability to handle the low limit you’ve established — $100 is good to start – before you increase their responsibility.  When they are old enough and ready for a card in their own name, encourage them to shop around for low rates and fees.

Discuss the importance of a good credit history and how a bad one can get in the way of future borrowing, whether they need to buy a car, rent an apartment or get a mortgage for a house. Show them how to get a copy of their credit report.

The U.S. Treasure has created an online interactive game called “The Bad Credit Hotel.” http://www.controlyourcredit.gov

Next week is the final part of this series: The Messages You Send

Funny Money Answer: The first credit card came out in 1951, produced by American Express.

BTW, Thanks to all who completed the questionnaire yesterday. Lots of great info there. And clearly y’all feel there’s a need for some consolidated, focused effort in teaching kids about money. I’ll summarize next week. In the mean time, encourage friends and family to do the survey so we can get a great sampling. Purrrrhaps the media will pick up on this a bit more and we can have a national discussion. Hmmm.

Very often I tell my fams that one of the ways to deal with high interest rates on existing credit cards is to apply for a lower-rate card and transfer the balance. When lenders were throwing credit this way and that, it wasn’t unusual to come home to find a balance transfer offer from some credit card company. And while transferring your balance from a card with a 28.8% rate to a 2.5% interest rate may seem like a no-brainer, there are a few things you should watch for.

The first thing to check is how long the lower rate will last and what the rate will be when the special offer period is over? Offer periods vary from six months to twelve, after which the card will revert to the normal (usually much higher) interest rate. If you can’t pay your balance off before the rate skyrockets, you may be stuck paying even more than before.

Note on your calendar, in your day book or in Big Fat Red Capital Letters on your wall the date that the special promotional interest rate ends and plan to either have the balance paid off in full or have a plan to transfer the balance to a cheaper option when the higher rate kicks in. The credit card company isn’t going to remind you, so if you don’t keep track you can’t go whining about what fiendish louts they are.

Make sure you understand what the low rate applies to. There are generally three type of transactions you can have on your credit card: a cash advance, a balance transfer, and purchases. Each of these transactions often has a different rate, with cash advances usually highest. If the offer you receive applies only to a balance transfer, do not make additional purchases on that card. Why? Because every payment you make will go against the balance transfer, leaving the new purchases to build up interest at the higher interest rate. Really! That’s what happens! Believe it!

Are there any fees associated with the balance transfer? Balance transfer fees are usually buried in the mouse print so read thoroughly before you make your transfer. Many people receive offers with no balance transfer fees and that will be clearly stated.

While you’re always supposed to pay your credit card on time, missing your due date by even one day on a balance transfer will result in the lender switching you automatically from the promotional rate to the standard rate, no ifs, ands, or butts.

If you do a balance transfer, you have to cut up the old card. Don’t cancel the account for six months so you don’t lose the credit history. But don’t fool yourself into thinking that you’ve taken care of the problem and that you now have even more “free money” to spend. This is one of the biggest traps of balance transfers. If you forgive yourself and don’t get a handle on your expenses – if you continue to think of credit as disposable income – then it’s only a matter of time until you’re pulling your hair out and running naked through the streets screaming!

Remember that credit card companies don’t make low-interest balance-transfer offers out of the goodness of their hearts. They know the odds are on their side that you’ll fail to pay off your balance on time, triggering the higher rate or neglect to switch your balance to another credit card when the promotional period is up.

Make sure you like the features of the card to which you’re transferring. A card with an annual fee is a card that costs more. Call it a fee, call it interest, the point of the transfer is to get those costs DOWN.

And please, please, don’t forget about your old card. Until you receive some sort of confirmation that the balance has officially been transferred, you still need to meet the next due date of your old card, or you risk getting slapped with a late fee.

People have a b’zillion questions about credit and how it works. And just when I think I’ve covered everything, I get another great question that makes me realize why people are so buggered up about credit: It’s really complicated man! Jeez! So here are some recent questions and answers from which you may learn and thing or two.

Kerrie wrote:

I recently noticed that the credit limit on one of my credit cards had been increased by a lot – far more than I would ever need or want to put on a credit card. I always pay the balance on this and my other cards in full. I plan to call the company to have this limit lowered to something more reasonable. I wanted to check first though – does lowering my credit limit have any negative impact on my credit score? Common sense tells me it should improve my credit score, but I wanted to check with you.

Kerrie, lowering your credit limit won’t affect your credit score if you pay off the balance on your credit card every month. The only time a lower credit limit has an impact on your score is if you’re carrying a balance and you get close to the limit. Some people say you shouldn’t use more than 60% of your limit to stay on the good side of the credit score system. Since you always pay your balance – smart girl – you should lower your limit for two reasons:

• You’ll feel more comfortable, and
• You’ll reduce your “available credit,” which is something lenders take into account when they decide whether or not to give you a loan.

J wrote:

I have very good credit (I know that because I just double checked my credit score). However my daughter – who isn’t quite 20 yet – has needed to get a consolidation loan which I had to co-sign. So far she’s made all the payments but how much am I at risk for my credit being damaged? The bank wasn’t all that straight forward on this one.

J: You’re on the   hook for the whole amount outstanding, but your credit history won’t come into the picture unless your daughter defaults and they come to you for payment. If you pay off the debt in full, your credit won’t take the hit. If you can’t and payments are missed then your credit score will go down. You should also keep in mind that lenders consider the co-signed loan as part of your debt obligation so it could affect your ability to borrow for your own purposes.

Y wrote:

Hi Gail! As a couple with jobs in middle management, making a respectable earning (household gross income of $130k), I am hoping you can help us. We are well aware of the mistakes we have made, student loans, consolidation loans, bad car leases and high consumer debt. Lessons learned, and we want to move forward with our best foot, but is it possible that it is just too late!? Despite our difficulties with money, we have gone ahead and bought a house (our mortgage is always paid), and continued with “life” in that we have 2 children (neither involved saving before my maternity leave which does not include any kind of company top up). I am currently on maternity leave and will be returning to work asap to avoid digging a deeper hole. In the meantime, the bills continue and there doesn’t seem to be any reprieve. At what point is filing for bankruptcy the better answer, and can 1 person out of a married couple file for bankruptcy without a detrimental affect on their partner?

Y, one partner can file for bankruptcy without affecting the other as long as the other is not also signed on the loan documentation. So if your husband has a card in his name, and you are in no way signed on that card, if he declares bankruptcy it will not affect you at all. As for it being too late, it is never too late. You may not like living through the next few years because you’re going to be living on a shoe-string. But you can make your life better with grit and determination. Go and read this blog about becoming debt free. If when you figure out your monthly repayment amount it is in no way do-able because you just can’t find the money anywhere, then bankruptcy may be the next option.

V wrote:

I recently got my [Life Planner] in the mail and have been getting all the info. I need to complete the budget worksheets. I’m going to get the jars started this month. Our debt has been causing me sleep loss. My husband and I have accumulated over $84,0000 in debt. It has grown to that from over spending, student loans, poor financial decisions and never living on a budget. Our debt is all consolidated into the Scotialine Visa (current interest rate of 3.5%). It’s humbling every month to open the Visa statement and see that number…$84,000 (Wow!). Our mortgage is up for renewal in 2010. We bought our house 5 yrs ago and our mortgage is currently around $250,000 (4.5% interest). I would like to roll some, if not all of our debt into the mortgage when we renew. Is this advisable?

V, how did you ever qualify to have $84,000 on a credit card? That’s just ludicrous. You don’t say how much equity you have in your home, but if it’s just five years old (with the recent downturn in the market) you may not have enough to cover the debt. And since your credit card interest rate is lower than your mortgage rate, that means you’ll be paying more in interest. AND once it is rolled to  your mortgage, it can’t be discharged through a bankruptcy in the same way it can as a cc. So my answer would be to do more homework, visit a bankruptcy trustee to see what alternatives you may have, and cut up the fricken’ card!

H wrote:

Hi Gail! I read your section about student debt and it was really helpful. In 2010, at the end of my 5 years at school, I expect to be about $26000 in debt. The National Student Loan Service Centre has a really helpful loan calculator to determine monthly payments, and my question is – should I go with a floating or fixed interest rate? And, if I choose one over the other, is there any way to ’switch’? The calculator estimates that the floating interest rate will result in lower interest payments, but I know it carries more risk. Also, the Ontario student loan has an eight month grace period until payments begin; I usually have leftover OSAP at the end of the school year and want to use that, plus as much as I earn in the 8 months after, to ‘throw’ on to my principle in lump sums before I start making payments – is that a good idea? Thanks!

H, you ask great questions. When you choose a variable rate, you pay a far lower interest rate, but it means you have to keep your eye on interest rates because if they rise, more of your money will go to interest. I believe the spread right now between fixed and variable n student loans is about 5 points, which means rates would have to rise SIGNIFICANTLY to make the fixed-rate loan more attractive. If you’re planning to get that debt paid of PDQ, I’d go variable. I don’t know if you can switch. I expect you can go from variable to fixed, but as variable rises, so would fixed. You would be wise to use your left-over OSAP and anything you earn to knock a whack off your debt. It is soooo gooood to hear from a sensible girl.

Sandi wrote:

I recently received an offer from a credit card company for a balance transfer, with a much lower interest rate than I am currently paying on my credit card. I called Visa and asked them to lower my rate to match the rate of the new card and I was told that it culdn’t be done, that the interest rate I have on my card is a “standard interest rate” and cannot be lowered. She also told me I couldn’t speak to a suprevisor because it wouldn’t do me any good. Where do I go from here?

Sandi, why would you want to deal with a company that is so uncooperative. You can’t speak with a supervisor? Really? First, I would call the company back and ask to speak with the vice-president of the department since you think (s)he should know how employees are representing the company to clients. You are, after all, a CLIENT.  Let’s see if that gets you anywhere. If not, then I’d accept the offer from the other credit card company to do the balance transfer, assuming there are no hidden fees or “tricks” up their sleeves. So read the paperwork carefully. Do not cancel the old card. Just stop using it. You want that credit history to remain intact until you’ve built up a history on the new card. I would tell the credit card company who has not treated you well that you will be telling everyone you know the story. Finally, get that debt paid off. You should be doing everything you can to pay off all your consumer debt as fast as possible. Times they are a’changing, and being debt-free will be your ace in the hole.

On a final note and from personal experience, when you cancel a credit card, that does not mean that all the charges to that card automatically stop. Much to my surprise, I cancelled my HBC card, which I only used for online transactions and like to change periodically for security reasons, only to find that the transaction for my daughter’s facial product went through on the cancelled card. Hmmm. Good thing I hadn’t set up the auto-ship plan on the new card just yet! If you want a card to actually be cancelled, it appears you must report that card lost or stolen to ensure no further charges go through. 

Once upon a time the only kind of credit you could get was called “installment” credit. You had to make monthly repayments that were designed to have that debt paid off within a certain period of time. So you might borrow $12,000 to buy a new car, with the plan to have that paid off in two years, so your payments would be about $560 a month. You knew exactly when the debt would be gone, how much interest you’d pay, and how much you were making a commitment to repay every month. And you had to have a good reason for borrowing. Lenders were loath to just hand out money willy-nilly. You had to justify your borrowing, which made you think. Those types of loans are still around; your mortgage is one.

Much more popular today is “revolving” credit. Lines of credit and credit cards are the primary examples. You can borrow money, pay it back and borrow it again at your whim. You don’t have to explain anything to anybody. You can use it to buy furniture, a car, food. Unfortunately, you don’t have to think too hard or too long before you go and rack up some debt.

When the personal line of credit first came out – I was there, that’s how old I am – they were offered to those people who were most “worthy.” These were borrowers who had proved they knew how to manage their money. They had a high net worth. They borrowed routinely to renovate their houses, finance business ventures, or invest. They were usually building their assets.

When credit became a commodity, FIs started to “sell” credit. Like a toaster or a handy-dandy wrench, credit became something everyone should have and use. And revolving credit became the name of the game. It had cache. It had style. It had unlimited possibilities in terms of generating interest revenues!

And we bought. Like pigs to slaughter, we signed up for as many different sources of revolving credit as we could. We bragged about how many credit cards we had in our wallets. We talked about our latest venture and how we had financed it with our lines of credit. We fell hook, line and sinker for the idea that an emergency fund was a done deal if we had a line of credit. Hmmm.

That’s not to say that revolving credit is in and of itself a bad thing. Nope. I love revolving credit because it puts me in the driver’s seat when it comes to getting rid of my debt. But I will tell you that it’s not suited to everyone. It takes discipline and a firm commitment to money management to bridle this bronco. Without a firm hand, you can find yourself on the ground being stomped to death by wickedly high interest and a never-ending repayment schedule.

On the upside, revolving credit is one of the best ways to build a credit history and shine your credit score. Used and repaid on a regular basis, it creates a record of positive credit management behaviour, which will stand you in good stead when you need to borrow lots of money for something important, like buying a house.  That’s because trust is built through experience, and when a lender can trust you based on your credit history, you’re more likely to be approved and not pay through the nose for the privilege.

The best way to use revolving credit to YOUR advantage is to use a credit card to pay for the necessities of your life, things like groceries and gas. When you charge something, transfer the same amount of money you spent into a savings account set up explicitly for paying off the card. Come the due-date, you can use the money you transferred into your Credit Repayment Account to pay off the card in full.  There ya go: you’ve used and paid off your credit, added to your credit history, and stayed in the black. What a concept!