Picture credit cards like a hammer. Used appropriately, they can help build a beautiful home. Inappropriately….and that same hammer can tear your entire house down.
Let me start by saying, the intent of this blog is not to make a case for or against credit cards. Whether you are someone who regularly carries a balance, pays them off each month, or avoids credit cards altogether, it’s important to understand how they work.
Credit card companies charge interest on unpaid balances every single day
See the actual math below:
· Take your APR and divide it by 365 days to calculate the daily rate that is applied to your balance
· If your APR is 22%, you pay .060% interest every single day on what you owe.
· A $10,000 balance is charged $6 on the first day. The next day, you are charged .060% on the new balance of $10,006($6.003)
· After 30 days with no payments, your balance of $10,000 grows to $10,182.41
The daily interest automatically gets added to your balance, so tomorrow you will pay interest on the interest from today.
APR determines your interest charges
APR stands for Annual Percentage Rate and represents the yearly interest charged if you carry a balance. A $10,000 balance with 22% APR costs $2,200 per year if you never pay it down. But daily compounding ballons this interest to $2,460. And this is just on carrying a balance. Cash advances and balance transfers often have a higher APR.
Timeline of a purchase
When you purchase something with your credit card, it usually appears on your account 1-2 days after. All transactions throughout a month eventually enter a “grace-period” once you hit your closing date/statement date. Most of the time, a grace period lasts 21-25 days. It covers the time between your statement date and payment due date, essentially giving you a short window of interest-free time.
Those who use credit wisely love the grace period. It allows them to purchase something today and pay zero interest if the full balance is paid by the payment due date. If you are eager, you can even pay off a purchase immediately after swiping your card.
Interest starts accruing if you carry any balance past the payment due date
If you carry just $1 past the payment due date, interest becomes your enemy. The interest calculation begins from the original purchase date, not the due date.
· Purchase an item for $1,000 on August 1st with a due date of September 1st at 24% APR
· Pay $999 on September 1st, and you’ll be charged interest on the full $1,000 from August 1st
· That means 31 days of interest at 24% APR, resulting in $20.27 of interest
· Your next statement will show the interest added to your remaining balance
This interest lookback is what often catches people off guard and leads to paying excessive interest. You don’t see interest during a grace period, but it’s compounding daily in the background. As you may be noticing, using credit to your advantage is a very fine line. Even if you aren’t adding new purchases, the effect of compound interest starts to work against you.
Your payment is applied to interest first, principal second
Every time you make a payment, it goes to interest charges first and the actual debt second. This is why only making the minimum payment feels like you aren’t gaining any ground. Let’s say you have a $300 balance with accrued interest of $50. If you make a payment of $75, $50 would go towards the interest, and the remaining $25 would be applied to the balance.
Credit card companies use psychological tricks
Don’t beat yourself up too much if you have fallen victim to the lures of a credit card. The system is specifically designed to keep the consumer confused and spending.
· Multiple interest rates make it confusing to know your actual interest costs.
· Different statements and due dates are challenging to track. This leads to late fees and penalties.
Remember, a credit card is like a hammer. It can be helpful or destructive. Some people can safely wield a hammer, and others are best, leaving the hammer on the shelf. It’s important to know yourself and develop financial habits that help your long-term goals.