Understanding Credit Card Interest

Credit cards can be both a boon and a curse. If you're strapped for cash and really want to make that purchase, you can charge it and pay it off later. And if you have a rewards card, it may be even better because you can collect points or cash back. But, if you're prone to carrying a balance, you'll have to wait longer to pay it off because of the hefty interest that some companies charge. 

In fact, consumer credit card debt is expected to reach $4 trillion by the end of 2018, according to CNBC. Americans were paying as much as $104 billion in interest and fees combined by the end of March 2018. That's no surprise since the Federal Reserve reported in May 2018 that the average interest rate on a credit card was an astronomical 14.1%, and some can run as high as 30%. So if you find it hard to get ahead with that kind of baggage, know that you're not alone. 

But it may help lessen the impact of credit card debt on your finances if you were better able to understand just how interest and rates work. Here are some basic notes to help you as you lower your credit card debt. 

Interest, typically expressed as an annual percentage rate (APR), is the fee paid for the privilege of borrowing money. This fee is the price a person pays for the ability to spend money today that would otherwise take time to accumulate. Conversely, if you were lending the money, that fee/interest compensates you for giving up the ability to spend that money today.

Interest is only charged on the money you owe at the end of each month. So, if you're not one of the fortunate ones who can pay off the balance each month, you will incur interest. Carrying a balance will come with extra fees. But those charges differ based on what you charge to your credit card. If you do a cash advance or a balance transfer, you may end up paying a higher rate of interest and other fees on those charges, compared to simple purchases. 

Some credit cards come with variable rates, so be sure to check the fine print. This means that the interest rate changes with the prime rate. Prime is the interest rate set by your lender, which is a few points higher than the federal funds rate, set by the Fed. If that rate goes up, your credit card rate will too. So keep that in mind when you're using your card.

(For more, read Understanding the Time Value of Money.)

The interest rate that you see on your statement or terms and conditions of your card is noted in annual terms. The cardholder will determine your purchases based on the daily rate, which is your interest rate divided by 365. The credit card company will then use that daily figure and multiply that by your balance at the end of each day. 

For example, if your card comes with a rate of 16% annually, the daily rate would be 0.044%. If you had a balance of $500, you would incur $0.22 in interest for a total of $500.22 the next day. That process continues as you make new purchases until the end of the month. If you had a balance of $500 at the beginning of the month and no other charges, you would end up with a bill of $506.60 with interest. 

The average credit card debt carried by U.S. households in July 2018 was $8,395. In fact, credit card debt accounts for a very sizable chunk of total revolving consumer debt, which hit nearly $1.04 trillion as of July 2018. Clearly, credit cards are an important part of our day-to-day lives, which is why it’s important to understand the effect of that interest on the total you pay.

Let’s say John and Jane both have $2,000 debt on their credit cards, which require a minimum payment of 3%, or $10, whichever is higher. Both are strapped for cash, but Jane manages to pay an extra $10 on top of her minimum monthly payments. John pays only the minimum.

Each month John and Jane are charged a 20% annual interest on their cards’ outstanding balances. So, when John and Jane make payments, part of those payments go to paying interest and part goes to the principal.  

Here is the breakdown of the numbers for the first month of John’s credit card debt:

• Principal: $2,000
• Payment: $60 (3% of remaining balance)
• Interest: $2,000 x 20% x 12 months = $33.33 [Simple Interest]
• Principal Repayment: $60 - $33.33 = $26.67
• Remaining Balance: $1,973.33 ($2,000 - $26.67)

These calculations are done every month until the credit card debt is paid off.

In the end, John pays $4,241 in total over 15 years to absolve the $2,000 in credit card debt. The interest that John pays over the 15 years totals $2,241, higher than the original credit card debt.

Because Jane paid an extra $10 a month, she pays a total of $3,276 over seven and a half years to absolve the $2,000 in credit card debt. Jane pays a total $1,276 in interest.

The extra $10 a month saves Jane almost $1,000 and cuts her repayment period by more than seven years.

The lesson here is that every little bit counts. Paying twice your minimum or more can drastically cut down the time it takes to pay off the balance, which leads to lower interest charges.

However, as we will see below, although it's wise to pay more than your minimum, it’s best simply not to carry a balance at all.

As an investor, you would be thrilled to get a yearly return of 17% to 20% on a stock portfolio, right? In fact, if you were able to sustain that kind of return over the long term, you would rival investing legends such as Peter Lynch, Warren Buffett, George Soros, and value-investing guru Jim Gipson.

Yet, if you received an email with a subject line that screamed, “20% Return Guaranteed!” you’d likely be skeptical. But think about it: There’s at least one guarantee that is ironclad: If your credit card charges 20% interest per year and you pay off the balance, you are guaranteed to save yourself from losing 20%, which, in a way, is the equivalent of making a 20% return.

Investors are often reluctant to pay down their credit cards and instead, choose to put the money into investing or savings accounts. Many factors drive individuals to do this. One of these factors is people’s tendency to have mental accounts, which causes them to place a different meaning on different accounts and on the money held in them. Mental accounting sometimes prevents investors from looking at their finances as a whole. Holding a costly credit card balance while using the money for investments actually negates any investment gains you might make. Unless you’re a world-class investor, investing instead of paying off your credit card balance is a guaranteed loss of money. On the other hand, paying off your credit card debt guarantees you a return, a return of whatever your card charges you. So remember, $1 is $1, regardless of whether it is invested or lost. Not thinking this way can be very costly.

If you have money in your investing or savings account, or you have $1,000 burning a hole in your jeans, take that money and pay off your credit card. Once you eliminate your high-interest debt, you’ll have more money, because you’re not making interests payments and because your investments will truly grow.

(See Understanding Investor Behavior, if you’re interested in knowing more.) 

The moral of the story: Carrying a balance on your card can be very costly. Pay off your credit card balance entirely. With the astronomical interest rates that credit card companies charge, it simply does not make sense, if you have savings elsewhere, to carry a balance. If you can’t completely pay off your balance, at least increase your monthly payment, even a little bit. It will be more profitable in the long run.