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.
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!
- Start Taking an Interest in Interest
- Start Taking an Interest in Interest: Mortgages
- Start Taking an Interest in Interest: Personal Loans
- Start Taking an Interest in Interest: Student Loans
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