Credit cards 101

Some people’s experience of credit cards is the equivalent of financial imprisonment. This often follows the view of credit cards being the same as free money.

It’s easy to get caught in this trap. After all, you probably experienced a school education where you solved complex mathematical problems and studied classic literature, but no classes were offered in personal financial management.

You probably didn’t learn the practicalities of how interest compounds on a credit card, and how the $20 meal can actually end up costing you $40 or more. It’s also never been easier to take that vacation now and pay later – you don’t need to do the boring work of saving beforehand. And everyone else does it, so it doesn’t occur to you to do things any differently.

If this sounds like you, here are some basic tips to get you better acquainted with the reality of credit cards.

1. Don’t carry a balance on your credit card

A credit card balance is one of the highest interest rate loans you can have. Read the fine print of your contract. You could have something like a 60-day interest-free period, so pay off your whole balance before this time period expires. Better still, budget to make sure you can pay it in full each and every month.

2. If you do have a balance, switch to a credit card that offers an interest-free period

Check which banks have the best offers, then switch and make sure you can pay it off before the interest-free period expires. Also, cut up the old card to avoid running up more debt.

3. Limit the cards you have

Why do you need more than one card, really? It’s asking for trouble by making it harder to track your budgeting. Limit yourself to one card, and don’t increase the limit to more than you can comfortably afford to repay.

4. Always pay more than the minimum

If you can’t afford to pay out the whole balance, at least pay more than the minimum. A balance of $1,000 at an interest rate of 18.5% will take over eight years and a total of $1,924 to repay.

5. Rewards cards aren’t necessarily so

There are plenty of frequent flyer and other rewards cards that look like they give you free money. But, really, the interest rate is probably higher and you may have to spend your annual salary on it to see any benefit.

6. Watch the fees

Many credit cards charge annual fees for simply the privilege of having their card in your purse, but you could also be paying fees for late payments, or when you can’t meet the minimum payment. Shop around for a better deal.

7. Stay away from store cards

They can be so tempting because you have more to spend in your favourite store, but this extra source of credit could add up to more than you can comfortably handle.

8. If you can’t trust yourself, get a debit card instead

If you find it all too tempting knowing you have free money in your purse, get rid of the temptation altogether and use only the money you have saved. When you run out, you stop buying. You won’t get into massive debt so easily this way.

A credit card can contribute to your financial freedom rather than financial imprisonment if used the right way. Learn how to make it work for you, otherwise get rid of it before you end up in a financial sinkhole.

Avoid the trap of turning your home loan into an investment loan

Question:

We have paid off most of our home loan and we want to upgrade to a new home but keep this one as an investment property.

Can we withdraw the equity in our current home and use it as a large deposit in our new home, with the added benefit of increasing the tax deductibility of the investment loan?

Answer:

No, the tax man doesn’t see it this way. You need a little foresight – well, a lot actually – to make this strategy work.

If you were to redraw some funds from your original home loan, it would be considered a new loan when it comes to tax. It’s the purpose of the redraw that determines whether the interest on that portion would be tax deductible.

In your case, using the funds as equity in a new owner-occupied home is not considered to be for investment purposes, and you could be in trouble with your taxes if you attempt this strategy.

But there is a way you can do this without being any worse off. You can get the advantages of paying down your original home loan and not get caught in this trap by having an offset account.

You could set up your home loan with a linked offset account and, over the years, rather than paying down your home loan with accelerated repayments you could instead build up savings in your offset account. Your interest bill would be the same.

The money in your offset account can provide you with a substantial deposit for your new home when you are ready to upgrade, and it allows you to maximise your interest deductibility.

You would simply withdraw the money from the offset account as all or part of your deposit on your new property and the interest on the full amount of your existing loan would be tax deductible.

Financially this could leave you in a much better position – but remember that you must act to set this up before you start paying down your original home loan.

And of course, speak to your accountant about your personal circumstances before making any decisions.

Supercharge your mortgage

If you have a mortgage then the chances are you know what it feels like to be chained to your bank.

But, did you know that an offset account can save you interest on your home and can help you pay it off sooner? It can be a truly powerful tool if used correctly.

Simply put, an offset account is a separate account that’s linked to your mortgage account, and money sitting in that account offsets the interest charged to your loan. You would need to make sure that the interest rate on your mortgage is variable as it rarely applies to fixed home loan rates.

For example, if you have a loan of $300,000 and $50,000 sitting in an offset account, then you would be charged interest on the net balance of $250,000 only.

A more attractive scenario is to have your $300,000 mortgage, plus the same sitting in an offset account. You wouldn’t be charged any interest at all in this case.

Many offset accounts act like bank accounts where you can have a cheque book, you can withdraw cash from an ATM, plus have direct debits set up to pay your bills. You can redraw any amount you want, just like a normal bank account.

And the news gets even better. Because interest on your home loan is most probably calculated daily, any funds sitting in the offset will reduce the interest charges.

A quick way of estimating your annual savings starts by estimating the average balance in your offset for a year. Let’s say it’s $10,000. If your mortgage interest rate is 6%, then your saving for the year would be $600.

$10,000 x 6% = $600

If you have a principal and interest loan, your bank may still expect you to pay the same regular instalment based on the outstanding amount in your mortgage. In this case, a greater amount of your repayment will go towards paying down the principal of your loan, helping you to pay off your home loan sooner.

A $600 interest saving means that your principal will reduce by this same amount – helping you to reach the goal of paying off your home loan sooner.

If your loan is interest only, the net amount (mortgage less offset balance) will be used to calculate the interest payable, and this will reduce as the balance in your offset increases.

Importantly, you need to understand that the effect of an offset account would be the same  as if you had put extra funds directly into your mortgage.

So why bother? The advantage of an offset account is that you can make your spare cash work harder. Rather than sitting in a bank account earning 2 per cent or less, you can make it earn the equivalent of your mortgage interest rate.

While this is great news for your own home, beware of the tax implications if you are using an offset account for an investment property. If you withdraw funds from an offset account linked to an investment property to use for personal purposes other than another investment loan, then you lose the tax deductability for that amount. This is a mistake that cannot be undone.

Of course, speak to a tax accountant for more information based on your personal circumstances.