How does credit card interest work?
At one point or another, we’ve all run into a situation where we haven’t been able to pay the full balance on our credit cards. For some people, this happens merely once because of unfortunate circumstances or high expenses. For other people, it might be something that pops up every year or two. For other people, paying credit card interest is a way of life, as they can never seem to get out of the cycle of paying minimum payments.
I’m not here to pass judgment. Life isn’t always easy, and different people have different strengths and weaknesses. However, I am here to provide facts and information so that you can get yourself to better financial footing. Part of that is understanding how credit card interest works, and why it’s generally a bad idea to pay it.
Every credit card out there has an interest rate that the issuer will charge you if you don’t pay your balance off in full every month. The interest rate is set by the issuer as what is known as an annual percentage rate (APR). Generally, the APR is based on another interest rate, such as the prime rate, LIBOR, or any other rate the issuer deems to be fundamentally important to the cost of borrowing. Credit card interest rates are typically far, far higher than other rates of interest. While mortgage rates in recent years have varied between three and five percent for a 30-year fixed-rate mortgage, credit card APRs can consistently be north of 15% in many cases, and above 20% in certain situations as well.
It’s also important to note that credit cards may not have just one interest rate.
They may have an interest rate for purchases made on the card, another rate for balances transferred over from other cards, and a third rate for cash advances from your credit card. For example, a card may have a 17% APR for purchases and a 25% APR for balance transfers. So it’s really important to understand how you are using a credit card so that you can look at the correct rate of interest you are paying.
To make it even more complicated, credit cards may offer you certain teaser deals designed to get you to spend more, or even bring other balances over to your card. They may offer 0% APR on all purchases for the first year, or maybe a teaser rate of 3% APR on balance transfers for six months. That being said, it is important to understand the length of time these teasers are in place for, and what happens to your interest rate when they expire if you think there’s a chance you may still have balances outstanding when the teaser period is up.
So how do we actually calculate the amount of credit card interest we have to pay if we have an outstanding balance we haven’t paid off?
First, we look at the applicable APR. Let’s use 17% in this example, because complex, hard-to-divide numbers are always fun to play with. The first thing we need to do is convert this to a daily rate, since unfortunately, there are not an equal number of days in any month, which makes this even more fun. So we divide 17 into 365 (since that’s how many days there are in a year) and we end up with 0.04657. That is the daily rate of interest you have to pay on an outstanding balance. So to bring some easy numbers into this, if you had that balance outstanding for one day on $100, you’d owe a little over four cents, but the bank would probably round it up to five cents.
But credit cards won’t charge you for a day of interest. They’ll charge you for the entire billing cycle that you had the debt outstanding, which will vary based on the length of the month. Let’s use a 30-day billing cycle in this case. So for that calculation, we’ll multiply the daily rate by the number of days. This gets us to 1.397%, but let’s make it 1.40% so we can continue to move towards simpler math as opposed to the complex math we used previously. What this means is that if you have debt outstanding for a whole billing cycle and that cycle is 30 days long, you owe 1.4% of your outstanding balance to the credit card company in interest payments. So if you have $100 outstanding, that means you owe $1.40 per month in interest to keep that balance where it is, using a 30-day billing cycle as a guide. Months like February and October that are either shorter or longer will have slightly higher or lower charges.
Let’s play out the string on this. Suppose you don’t have $100 outstanding but $1,000 in purchases. And suppose you have that same 17% interest rate. That means you owe $170 per year in interest to the card issuer. That’s almost $15 per month that you are paying in interest, rather than either being able to stash away or put towards an item of need. That’s money you can’t put into a 401(k) plan. It’s money you can’t save to buy a house. You can’t write it off on your taxes. And the interest rate is high. So there’s a real incentive to pay that off, because it can free up cash flow for you.
So if you’re wondering how much you should pay on your credit card each month, the simple answer is to not carry a balance if possible. Be careful with credit card points offers. Get your credit score as high as possible. All of these things can help you to escape the feeling of being trapped by credit card debt, because with the way interest is structured, it can be really difficult to dig out if you find yourself in a cycle where you need to maintain a balance from month to month. Credit card interest is actually fairly simple to calculate, and the math shows it’s a bad deal for most individuals except when there is no other option.