credit card interest

Start Taking an Interest in Interest: Credit Cards

Now let’s talk about credit cards, the loans that most people will pay interest on.

Credit cards are a little different because they are revolving credit, meaning that the amount of credit extended can be borrowed again once paid. They are also different in that the interest on any balance carried is charged daily.

Yes, daily

However, the method used to calculate this daily interest is pretty confusing. Let’s start with the interest rate, which is pretty straightforward. Each credit card has an APR, or annual percentage rate. To get the daily periodic rate (DPR) used to calculate interest, simply divide the APR by 365 days.

Here’s where it gets tricky. Credit card lenders use something called average daily balance to calculate how much interest you owe because your balance fluctuates throughout the billing cycle. Calculating average daily balance is extremely complicated, so for now we’ll give a very simple example.

Let’s say you buy something for $500 on day 1, then something for $300 on day 15, then pay $200 on day 25 of a 30 day billing cycle. You have 14 days with a balance of $500, 9 days with a balance of $800 ($500+$300), and 6 days with a balance of $600. Average daily balance would be calculated as follows:

 

(500×14) + (800×9) + (600×6)

7,000 + 7,200 + 3,600 = $17,800

$17,800/30 = $593.33

Average Daily Balance = $593.33

 

To calculate the interest owed for this hypothetical billing cycle, simply take the average daily balance and multiply it by the daily periodic rate, then by the number of days in the billing cycle.

For example, let’s say you have an APR of 15% (about the national average).

 

0.15%/365 = 0.00041096

DPR = 0.00041096

$593.33 x 0.00041096 = 0.2438

Daily Interest = 0.2438

0.2438 x 30 = $7.31

Total Interest = $7.31

 

The good news is that even though interest is calculated daily, the interest is not charged to you if you pay your balance in full on or before the due date. This is because you get a grace period with credit cards. Unfortunately, most people don’t pay their balances in full and are charged interest daily beginning with the initial balance for the statement period.

But wait a minute? We just did an example and the interest was only $7.31?

While $7.31 doesn’t seem like a lot of interest, it does add up.

Let’s look at a different example. Credit card companies calculate the minimum monthly payment as a percentage of the current balance (usually around 2% or 3%) or as a minimum fixed amount, whichever is greater. A common minimum monthly payment for a lower balance is $25. A reasonable amount. However, if you only pay the minimum payment on your 15% APR credit card and you have a balance of $500, it will take you two years to pay it off and cost you $79 in interest!

Two years to pay off a mere $500? That’s ridiculous!

But $500 isn’t a very big balance, what if you rack up $5,000 on that same card?

Let’s say best case scenario, the card issuer charges only 2% of the balance as the minimum monthly payment. A table with the first 12 months of the payoff schedule for a credit card with 15% APR and a balance of $5,000 is shown below.

 

 

Notice how the minimum payment changes as the balance changes? This gives you an idea of just how much you would be paying on your credit card balance with these numbers. You’ll also notice that you’re paying more toward interest per month than toward your balance (just like a mortgage). However, the biggest thing to note is the total amount of interest you’d pay and how long it would take you to pay off $5,000 with the schedule shown above.

Ready for it?

If you only paid the minimum payment on the balance for a credit card with 15% APR, you would end up paying $6,973.68 in interest!

Not only that, it would take you 264 months, or 22 years to pay it off.

 

Moral of the Story

Absolutely, unequivocally do not stick to minimum payments on credit cards! In fact, credit cards charge so much interest that they are only beneficial as a financial tool if you pay your balance every month. If you pay your balance in full every month, or make a few smaller payments resulting in the total balance throughout the month, you won’t pay a dime in interest and can enjoy some pretty good benefits.

Whether you pay off your balance every month, or simply make large payments toward your balance, but sure to pay off your credit cards as fast as you can to avoid paying thousands in interest.

Talk about Money Saved!

 

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22 thoughts on “Start Taking an Interest in Interest: Credit Cards”

  1. My husband and I used to be so good at paying off our card every month. We are working hard to get back to it. Our balance is not that large and only on one card but still the interest kills!

  2. Great post! I think, unfortunately, too many people don’t fully understand how credit cards work and just pay minimums thinking oh that’s such a small interest and payment!

  3. So interesting! Yes there are so many benefits to using cards— if you pay it off in full each month. We enjoy so much free travel on points.

  4. This is so important! Interest is killer–my husband and I pay our balance every month to avoid falling into the interest trap. I hope we can stay out of it for good!

  5. I’m just finishing paying my low limit CC off this month. I want to use my CC like my debit card because I get cash back, I’m just worried about racking up a balance after my one year of no interest wears off. It is my first CC so I’m happy I’ve got it paid down before any interest hits!

    1. Good job! Using a CC like a debit card is a very effective way of avoiding interest. If you have that mindset then you won’t spend money you don’t have. Maybe a good topic for a future article. You’re well on your way to shifting your mindset to frugalism!

  6. Whew! That is a lot of interest! I believe it is always best to pay off credit cards in full every month. it can be a great tool if you do so. However, if you are unable to do that… you may want to stay away from them because like you said… it can really add up! Great post!

  7. Great post! I can’t emphasize enough how crucial it is that people understand what happens when you don’t pay off your credit card statement balance in full every month. It’s crazy!! This message needs to be shared more, so I shared it on Pinterest 🙂

  8. I have paid so much interest over the years…it makes me feel gutted so I am just paying back as much as I can .thanks for sharing it.

  9. I stay away from the credit cards unless it’s an absolute must. And then I’m a nut until it’s paid off. This is a great post.

  10. I am so grateful to have been credit card debt free for almost 10 years, I will never go back! But I do use my cards for the points now!

  11. What an insightful article! Generally people aren’t much aware of these things and use it just for the conventional purpose. Thanks for sharing:)

  12. My husband and I are working to be debt free. Lots of sacrifices to meet this goal but in the end it will be worth it. Great article!

  13. I never thought about the importance of credit cards. Guess I’ll gather more info about getting myself one. Thanks for sharing this informative post.

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