Did you know that your bank manipulates your credit card repayments in order to maximise the cost to you (and the profit for them)?
It’s known as the inverse allocation of payments, which basically means that any repayments you make go towards the cheapest debt, leaving the highest interest-earning portion until last.
It’s a sneaky trick that is employed by all the big banks and building societies, with the notable exception of Nationwide.
Three-tiered interest
To avoid this trick, we first need to take a look at how interest is apportioned. As a general rule, today’s credit cards have three tiers of interest. These are:
- 1: Introductory rate: Any short term, low rate offer that you are given upon opening the account. Most commonly comes in the form of 0% new purchase or balance transfer offers that last roughly a year before reverting to the normal purchases rate.
- 2: Normal purchases/transfer rate: Standard rate of interest charged. Will apply to all spend on the card not covered by an introductory rate. Typical APRs on credit cards are usually around 16% to 19%.
- 3: Cash advances: Cash withdrawals earn the highest rate of interest, generally around the 25% mark.
This is the order in which your debt will be repaid, and it’s important you keep this in mind when using your credit card.
Spend with caution
Withdrawing cash should be avoided at all costs, as not only is the interest rate extortionately high, it’s also the most difficult debt to clear.
You must also ensure you don’t rack up any debt in the second tier until you completely clear those introductory debts in the first tier. This can be a lot trickier than you think, as many credit cards on the market today are designed specifically to catch you out in this regard.
Ho do they do this? By offering a lengthy 0% balance transfer deal combined with a short term new purchase offer, designed to tempt you into spending on the card as well. Once you do that, the banks have you exactly where they want you.
Here’s a practical illustration of how it works:
Short term gain, long term pain
Let’s assume you switch £3,000 debt to your new credit card, which offers 12 months interest free on transfers and three months on new purchases. You then have an unexpected £1,000 expense which you can’t immediately cover, so you put it on the card and plan to repay it before the 0% new purchase offer expires in three months time.
But when you do repay that debt, you’ll find those funds went towards the balance transfer instead. So after three months you still owe the £1,000 from that new purchase, and it is now earning interest at a rate of anywhere between 16% and 19%.
Before you can even begin to repay it, you have to clear the £2,000 remaining on your balance transfer.
How to beat the banks
There are two ways to avoid this trick: Either choose a card that offers identical new purchase and balance transfer deals, or simply use a separate credit card for each.
Personally, we’d recommend the latter, as it’ll get you a better deal – the longest dual interest free offer is 10 months, but you can get 14 months on new purchases with Capital One, and 15 months on transfers with Virgin.
