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Personal Finance Friday | How Credit Card Interest Works
Today we will discuss how the interest on credit cards compounds over time. Learn how the mistake of not paying off your balance can lead to hundreds of thousands of dollars of debt.
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Seriously, Credit Card Debt is Scary
I wrote about credit cards a couple of weeks ago in a general sense. At the time I mentioned how they are a necessary evil since consumers in the 21st century need credit history, but credit card debt is a slippery slope. Today’s newsletter is going to discuss how credit card debt can quickly spiral out of control. Happy learning.
How Do Credit Card Payments Work?
When you use your credit card, you’re essentially borrowing money from the bank to purchase something today. At the end of the month, all your purchases get added up and sent as a monthly statement from the credit card company. The total amount of charges during the previous month becomes your “balance”. You’ll have a 21-25 “grace period”/days once you receive your statement to make a payment towards your balance. If you make no payment, you’ll be charged a late fee. If you make a payment that is less than the total balance, you’ll avoid a late fee but will be charged interest.
April 1-30th: You charge $500 on your credit card
May 1st: Your balance of $500 becomes due on May 21st.
May 21st: You don’t pay, pay the minimum, or pay another amount towards your balance.
May 22nd: Your Balance decreases by your payment amount. If you make a payment below $500, your account will begin to accrue daily interest.
How Does Credit Card Interest Work?
Credit Card interest is the evil side of these money borrowing pieces of plastic. After the grace period, any remaining balance will begin to accrue interest DAILY. This is a big deal because when interest compounds daily, it grows the balance every. single. day. Right now, the average yearly interest charge on credit cards is 23%. To find the daily interest charge, divide 23%/365 = .00063. Multiple your current balance by .00063 and that is the interest added to your balance on day 1. On day 2, multiply day 1’s balance by .00063 and that makes your new balance and so on.
Example: 23% Annual Interest with $500 balance
Day 1:
(.23/365 = .00063)
.00063 x $500 = $0.31
$500.31 balance
Day 2:
$500.31 × .00063 = $0.32
$500.31 + $0.32 = $500.63
$500.63 balance
If we continue this trend, our balance will grow to $561.00 in six months. I know what you’re thinking; “who cares about a couple of dimes of interest per day, that’s nothing!”. Well, let’s say your balance was $2000 instead of $500. With a $2000 balance, six months of daily interest will grow your account to $2,245. At $10,000 six months of interest will grow to $11,228.
But There’s Another Catch…
If you’re the average American, you use your credit card every month. You continue to pay your bills month after month charging it on your card. After each month, you make your full credit card balance payments during the 21-25 day grace period and you never pay any interest.
Here’s the catch: If your balance for last month was $500 and you fail to make the full balance payment after the grace period, the credit card company will add ALL charges from last month and the current month. This means if today is the 27th of the month (past the grace period) and you charged $300 during this current month, your new balance is $800, and it will accrue daily interest immediately. Once you fail to pay the full balance off after the grace period, all future grace periods are removed until your balance is paid in full once again.
This is how drowning in credit card debt happens. You expect to pay only last month’s balance, but the day you fail to pay it off in full, all charges on your credit card become due immediately or daily interest will be charged. Long story short, always pay off your credit card in full and never make a minimum payment.
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