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18 Jul 2019

Could 'bad credit' credit cards be more expensive than a payday loan?

Some borrowers may be trapped in debt by subprime cards

Financially vulnerable borrowers are often offered credit cards with sky-high interest rates, on the promise of boosting their creditworthiness. But in some cases, these cards may end up costing more than payday loans.

Around four million people in the UK have subprime credit cards, charging interest ranging from 30% to 70% - compared to the average 20% APR on mainstream deals.

Used responsibly for short-term borrowing, these cards could help those on a low income or with poor credit files improve their credit history. However, debt charity StepChange says three quarters of its clients experienced a detrimental effect on their finances.

Which? explains how a credit builder card can lead to expensive debt, whether a credit builder card can help you and alternatives if you want to avoid using one.

Could subprime cards lead to a debt spiral?

Subprime credit cards are aimed at those who might not be approved for a more competitive card from a high-street provider because of their low income or bad credit history. As these customers are seen as risky, they are often offered higher APRs. So, counter-productively, the most expensive deals are often for those that can least afford them.

In a national YouGov poll, StepChange found one in three people with serious debt problems had a subprime credit card. Of these, one in four were behind on one or more essential bills, such as rent or council tax, when they applied.

Those with a subprime card also tended to have other credit cards. Eight in ten StepChange clients had more than one card, while a third had four or more.

StepChange chief executive Phil Andrew said: 'Our research points to a vicious circle. If you're in debt, you're quite likely to take out a subprime card; if you have a subprime card it's quite likely to exacerbate your debt.

StepChange has called on the FCA to prevent irresponsible lending to those that are a significant risk of falling into financial difficulty, including banning automatic credit limit increases.

It also wants the regulator to explore measures to address excessive costs, such as suspending interest charges and capping the cost of credit to 100% of the amount borrowed - as is the case with other short-term high-cost borrowing options like payday loans.

How much do credit builder cards cost

While subprime credit cards have relatively high APRs, these products can be affordable if you pay them off promptly.

For example, on a card that charges 35% APR, you won't pay any interest if you borrow £500 and clear your balance that month. Even if you choose to repay the £500 over three months, it would cost you a relatively modest £25.

This is much cheaper than typical short-term credit alternatives (like payday loans), that charge around £140 to £260 for the same level of borrowing.

However, StepChange found that subprime credit cards are not always used like this. Two in three of its clients say they only make the minimum payments, and the average balance on a subprime credit card was £1,348.

In these circumstances, the costs are much higher, even with new rules to combat persistent debt, which require interest to be reduced after 36 months.

If you borrowed £1,000 at an APR of 35%, and only paid the minimum payment plus interest, you'd ending up spending £1,130 in interest charges over 72 months. On a credit card with a 69% APR, that cost rises to £2,020.

By contrast, the total cost of a payday loan is capped at 100% of the amount borrowed - so you'd never be required to pay more than £1,000 in interest and fees for the above loan.

Can a credit builder card help you?

Credit builder cards can be effective if used in a responsible way, and may be a helpful way to build up a thin or impaired credit history.

In the latest Which? credit card survey, seven in ten of our respondents said their credit score had improved since taking out a credit builder card - compared with less than two in ten who said it hadn't.

To benefit from these cards, you should only ever spend what you can afford to pay back each month, to avoid paying interest and to improve your credit rating.

They should never be treated as a long term borrowing option. If you intend to use them this way, you should consider an alternative deal.

How to get a better deal on borrowing

If you struggle to get access to mainstream credit that comes with lower APRs, a credit union could help.

These institutions offer cheap loans to those with a common interest or bond (though rules have been relaxed on this criteria) and charge around 1% a month on the reducing balance of a loan up to 12.7% APR.

Or you may be able to ask your current account provider for a fee-free or authorised overdraft which may be cheaper than using a credit card.

Alternatively, you could focus on other ways to improve your credit score - getting your rental payments recorded on your credit file, for example, or making sure there are no errors on your report.

Improving your score will enable you unlock better deals on credit cards over time, like 0%-purchase credit cards offering long periods of interest-free spending.