We reveal how a lenders' trick known as the 'negative order of payment' could mean spending on your credit card costs far more than you bargained for.
What’s the trick?
Aside from making sure that any payment arrives on time, most of us give little thought to how our credit card debt is repaid. However, exactly how our lender allocates our credit card repayments has a huge impact on how much interest we pay and how much our purchases end up costing us in the long run.
This issue is so important because the vast majority of credit card providers adopt an approach called the ‘negative order of payment’.
This is where a provider allocates any repayments you make towards clearing your cheapest debts (those accumulating the least interest) and leaves your expensive debts (those accumulating the most interest) trapped on your card, attracting extra interest until the rest of the balance is paid off.
How does it work?
Credit card providers typically allocate different rates of interest to the different types of transactions made on your credit card.
For example, you’re likely to pay interest at one rate for standard purchases, another for cash withdrawals and, depending on the type of credit card you have, another for balance transfers. Individuals who have taken advantage of an introductory offer on balance transfers or purchases will also pay a different rate of interest on these types of transaction during the offer period.
While it may seem intuitive that all types of transaction would be taken equally and your credit card repayments spread across them evenly, this is not the case. Instead, most credit card providers allocate your credit card repayments in terms of their profitability.
Consequently, any repayments you make are put towards clearing the cheapest transactions (such as 0% balance transfers) that earn your provider the least money first, leaving the most expensive debts, those that earn your provider the most money such as cash withdrawals, stuck on your card accruing interest until the rest is repaid. This increases the amount of interest you repay on your credit card debt considerably.
Who does it affect?
The individuals who tend to be most affected by this rather cunning trick are those who take advantage of an interest-free introductory offer on balance transfers but then continue to make new purchases on the card. Those who make cash withdrawals on credit card (whether it is offering an introductory offer or otherwise) but are unable to clear their balance in full by their statement date will also be affected.
If you’re unsure as to how your credit card provider allocates your repayments you should check your latest statement as, by law, providers are now obliged to make this information available.
How can I avoid the trap?
Clear your card in full:
The easiest way to avoid trapping your expensive debts on your credit card is to steer clear of cash advances and pay off your balance in full each month. This way you’ll never pay any interest so the order of repayments won’t be an issue.
Avoid making cash withdrawals on your card:
Surprisingly few people realise that credit card providers typically charge interest on cash withdrawals from the day you make the transaction. Consequently, the usual 50-day or so interest free period does not apply and you’re stung with hefty interest repayments, usually charged at a rate upwards of 20%, from the word go. Furthermore, if you have other purchases or balance transfers on your card, this expensive debt will sit accruing interest at an exorbitant rate until the rest of your balance is cleared.
Check your repayment terms and conditions:
While it won’t necessarily make for an entertaining read, checking your credit card’s terms and conditions is something that’s well worth doing. In their t’s and c’s they should state exactly how your payments are prioritised as well as including lots of other useful information about the usage of your account. Remember, unless they specifically explain that your most expensive debts (usually cash advances and purchases made at the card’s standard APR) are given repayment priority over their cheaper equivalents, it’s fairly safe to assume that this isn’t the case.
Keep balance transfers and new purchases separate:
The vast majority of credit card providers apply a negative order of payment to your credit card balance so, if you’re planning on taking advantage of an interest free balance transfer offer, the safest thing to do is to never spend on the card.
Transfer your balance, work out how you need to repay each month in order to clear your debt by the end of the 0% period, set up a direct debit and then put the card in a safe place until the interest free offer expires and your transferred balance is repaid. By all means keep a separate card in your wallet for spending but make sure you pay this off each month and avoid making cash withdrawals so that your new purchases remain interest free too.
Avoid uneven balance transfer & purchase deals:
The above principle particularly applies to cards that offer uneven promotional deals on balance transfers and purchases.
Typically you’ll be offered, say, 12 months at 0% on balance transfers and 3 months at 0% on new purchases. This is all well and good if you only use the card to make a balance transfer and never for any new spending, or if you use it just to make new purchases and don’t transfer any balances across. However, the issue occurs if you mix the two .
In this instance, while any new purchases made within the introductory three month offer period will be interest free, as soon as this ends it’s likely that they’ll jump to the card’s standard APR and sit there accumulating interest at what is likely to be a significantly more expensive rate until you have repaid the balance transferred to the card in full.
Go for identical balance transfer & purchase deals:
If you’d rather just apply for one new credit card and need to transfer a balance and make new purchases it’s best to go for a card that offers identical introductory offers on both. Choosing a card that offers 0% for 6 months on purchases and 6 months on balance transfers removes the negative repayment problem entirely (providing you don’t use your card for cash withdrawals of course).
It is worth bearing in mind that cards that offer identical introductory deals on purchases and balance transfers tend not to be so generous with the number of months they give away interest free. So, you’ll either need to ensure that you’ll be able to clear the balance completely by the end of the interest free term in order to avoid paying any interest or factor in the cost of transferring your outstanding balance to a new card.
