Investment Glossary – Credit Card Interest

“Buy it now, pay for it later!”

That’s the beautiful promise of credit cards, made to millions of people each year who snap them up to buy whatever their heart desires. Yes, you can buy it now. Yes, you can pay for it later. But if you decide to go that route, you should know that most credit cards charge interest on purchases that aren’t paid off every month, and that the interest they charge can be incredibly high and costly. So I guess that means we need some re-branding.

“Buy it now, pay for it later…along with additional money you owe us for lending you the money until you paid it back!”

Not quite as catchy, right?

But that’s the premise behind how credit cards work. You ”swipe” now, and a financial institution loans you the money to pay for it, and then you have to pay them back. If you pay them back within the month, they don’t charge you interest. However, if you take longer to pay them back, then they do charge you interest. Credit card interest is additional money that institution demands from you by virtue of you borrowing the funds for a period of time.

Let’s say that I had a friend named Steve. Steve comes to my house one day and says, “Man, I could really use a new TV. Can I borrow $500?” Now, assuming I had $500, I might lend the money to Steve. But in doing so, I no longer have use of that money until Steve pays me back. I can’t use it to buy stuff to eat. I can’t save it and buy stocks with it. I can’t go buy a new TV of my own with it. I no longer have the money. But because Steve’s a really good friend of mine, I might lend him the money and just tell him to pay me the $500 back when he can. And hopefully he does.

But, credit card issuers aren’t your friends. They are businesses designed to make money. And there’s nothing wrong with making money. But you have to understand who and what you are dealing with when you are dealing with credit card issuers. Most issuers are banks or other financial institutions that partner with a credit card network (Visa, MasterCard, American Express) that handles transactions. The networks typically make money via a small transaction charge on each purchase you make, but the banks make money on annual fees and the interest they charge you. When they lend money to you to make a purchase on your credit card, that’s money they can’t lend to someone to earn 5% on a mortgage payment. It’s money they can’t lend to someone to earn 8% on a car payment. And unlike a mortgage or car loan, if you go into credit card delinquency and eventually default on your debt, there typically isn’t any collateral they can go and claim. So the interest rate on credit card tends to be pretty high in order to compensate card issuers for the increased risk.

Interest rates on credit cards can easily be higher than 15%, and in many cases north of 20% as well. With all of that interest accruing , that’s money you can’t spend elsewhere or save. So if you’re thinking about just making minimum payments on your credit cards, think again and make sure you’re just building a wall of interest that you’ll struggle to pay off. Yes, you can buy it now. But make sure you understand that if you can’t pay your credit card off every month, while you may be able to pay for it later, there are likely a whole bunch of interest charges you’re going to have to pay for as well.