Learn how credit card interest works, how to avoid falling into compounding debt, and the technical side of interest.
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When looking at interest rates on credit cards, the interest rates are usually stated as a yearly rate. This is known as the annual percentage rate or APR. Most cards allow you to avoid paying interest on purchases only if you are able to pay the balance in full each month by the due date.
The average APR on credit cards is 19.05%. However, this varies drastically based on the card on the credit score and creditworthiness of the cardholder. Some have introductory offers as low as zero percent interest and others go as high as 34.99%.
Credit cards have become a necessary evil in today’s society with many transactions only able to be completed with a credit card.
Simple transactions such as booking a hotel, booking a flight, renting a car or making an online purchase all require a credit card. This makes it harder and harder to pay using cash or debit, pushing people dangerously into debt and jeopardizing their financial future.
Credit cards have become a normal way of life for the majority of us and have changed how we view money and debt. Credit has become so readily available it has created a high-risk culture of ‘buy now – pay later’.
If you are like most people, you likely don’t know the interest rate on your credit card or know exactly how compound interest, which credit cards use, is calculated. Don’t feel bad about it. The credit card companies rely on this fact and intentionally make it hard to understand how compound interest is calculated.
Compound interest is how the banks make so much money on the credit cards. Simply put it means that you pay interest on the interest they charge you. Once the grace period has passed, most credit card companies are charging daily interest which further exacerbates the problem.
To understand it fully, we need to calculate how much interest you are paying on a daily basis. Find your APR and divide by 365 (days in the year).
Although you only see the interest charge appear on your credit card once a month, every day your credit card issuer runs a calculation that takes your current balance and multiplies it by the daily rate.
That interest is then added to your balance the next day, and the next day, and the process continues for as long as you have a balance on your card. The credit card companies don’t show the daily interest charge being added to your balance as this isn’t good for business.
An example:
Credit card balance – $2500
Annual percent interest rate – 22%
Calculated to daily percent – 0.06 %
Day 1 – Your interest is $1.50 on the first day after the grace period is over.
Day 2 – your balance is now $2501.50 and the calculation is run on the new balance with interest now being paid on the additional $1.50 of interest from the day before.
Credit card companies typically allow you a ‘grace period’– if you pay the balance in full during this time you pay zero interest. The grace period varies for each card and is usually between 21 days to 30 days.
What the banks rely on, is that most people using their credit cards for any type of major purchase do not have the ability to pay the borrowed amount in full during the grace period.
Although paying the minimum payment prevents any negative impact on your credit report and ensures you do not incur additional penalties above the APR, you are still charged the daily compound interest on the balance.
The minimum payments are intentionally set very low by the credit card companies to give the borrower the comfort that everything is fine as long as all payments are being made on time.
Minimum payments can be as low as 2%, meaning if you make only the minimum payment, any significant balance will take years and years to pay off.
For example, on the earlier mentioned balance of $2500, the minimum payment would be approximately $50/month, which would take close to a decade to pay off if there were no other charges added.
To know how the minimum payment is calculated on your card you would need to look at the cards ‘terms and conditions’.
Making minimum payments is so dangerous to your financial future that new regulations have been imposed with a requirement to show the exact amount of time it will take to repay the debt if you make only the minimum payments. Have a look on your next credit card statement; it’s a real eye opener.
Interest is charged on a cash advance in the same way: interest charged on interest. Some cards charge a higher interest rate on cash advances and there is no grace period, so the daily compounding interest begins as soon as you take the cash advance.
It certainly can be beneficial if you have the right plan and a full understanding of what you are getting yourself into.
We have all received the offers in the mail, online, or over the telephone where it seems to make sense to transfer your existing credit card balance at 22% over to a new 0% card. This would mean that all your payments are going to the principle debt during the introductory period and not just slowly paying off the daily compounding interest.
Should a person opt for this, it would require a lot of discipline to not increase the balance on the new card, as the limit will likely be much higher than on the card from which you just transferred the balance.
You should also immediately stop using the card you have just transferred the balance from and cut it up. If you are disciplined and stick to the plan you can quickly pay down the balance and get out of the trap of minimum payments.
If you are not, you will end up with balances on both cards and be paying daily compounding interest on two cards when the introductory period is over.
Before you do anything, check the length of time on the low interest introductory offer and see if you can create a budget to significantly pay down the debt during the interest-free period.
Remember, the introductory offer only applies to the balance transfer and any new purchases will be charged at the standard interest rate. Also, any payments you make will usually be applied to the amount transferred and not to the new purchases so the balance of the interest-free portion is the first amount reduced.
Understanding how credit card interest works will help empower you to make educated financial decisions. It will remove some of the power from the banks and transfer it over to you.
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