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Knowing how credit cards work can give you the advantage you need to get rid of your credit card debt once and for all.
When you understand how interest is charged, you’ll make wiser decisions when deciding when to make a purchase, which credit card to pay off first, how much of a payment will make a difference, and how you can effectively get out of debt.
Let’s get started!
What is APR
APR is an abbreviation for Annual Percentage Rate. Because it costs money to borrow, this is the amount that banks will charge you presented as an annual percentage.
Without going into all the geeky details, credit card issuers get this number by using the U.S. prime rate (the rate for the average consumer as reported by Wall Street) in addition to their own margin (or cushion).
Prime rate + Margin = APR
When you open a credit card, one of the things you should be looking at is the APR. The higher the APR, the higher the interest you will be charged and the more money you will have to pay. Your goal is to get the lowest interest rate that you can.
Keep in mind, this is only when you carry a balance. If you use your card and pay it in full every month, you won’t be charged interest. I highly recommend paying your credit card in full if you use it.
*it is a credit myth that you need to carry a balance on your credit card to build your credit score. You are actually losing money by doing this.
For simple computing purposes, I will give you an example of how interest is charged.
Let’s say you charged $1,000 on your credit with a 20% APR. At the end of the year, you will have paid a total of $1,200. $1,000 for the original amount and $200 in interest.
However, this is NOT how credit cards work.
Most credit card issuers use a compounding interest model. That means that interest is charged on your balance each day, not each year.
If you are only paying the minimum balance each month, it might not be enough to cover the interest. In this case, interest is charged on interest.
This is why it feels that you can never get ahead on your credit card payments.
By paying the minimum amount, you might not cover the interest, resulting in a stagnant or increasing credit card balance.
Be very careful about promotional APRs. Some companies will offer a very low or even zero interest for a period of 6, 12, or 24 months then charge you a sky-high interest rate after that.
Be sure to read the fine details and make sure to pay off your balance in full by the end of the promotional period.
Related: How to Pay off Your Credit Card Once and For All
How is the Minimum Payment Calculated
As far as I know, there are 3 ways that your minimum payment is calculated:
*To see how your minimum balance is calculated, please see your terms and agreements page in your credit card documents.
1) Percentage of your balance
If your bank issues your minimum payment via this method, you will be required to pay anywhere between 2-5% of the balance.
If your balance is $1,000 and your card issuer charges 3% of the balance, you will be required to pay $30.
This way is extremely simple. You can anticipate exactly what your minimum payment will be.
2) Percentage + Fees
Your bank may also decide to tack on fees to a flat percentage rate. These fees may include regular fees, late fees, and over-limit charges.
If your balance is $1,000, your card issuer may charge a flat 1%, then add your fees. So, $1,000 balance would incur $10 flat rate + $25 late fee = $35 minimum payment
3) Percentage + Fees + Interest
Some banks combine all of the above. Having the interest already included in your minimum balance is nice because you know that interest won’t be carried into the next month’s cycle.
If your balance is $1,000, your card issuer may charge a 1% flat rate, add your fee(s), and your interest charges.
So, let’s say your average daily balance is $1,000, your APR is 15%, and you have one late fee from last month.
- Flat rate of 1% = $10
- Fees = $25
- Interest = $12.74
- Total minimum payment = $47.74
There are companies that work by tiers. This means that the way your minimum payment is calculated is determined by how much you owe.
If you owe less than $1,000 for example, you may only need to pay $25, or whichever is less.
I hope this helps to clarify some things, regarding how your payments are calculated and how credit cards work.
If you find that your minimum payment is calculated differently, please comment below so we can educate ourselves even further.
Related: What is the Fastest Way to Pay Off Debt?
How is Interest Calculated
First, I’d like to remind you that if you pay off your statement in full by the due date, you will not incur any interest charges. The interest will start accruing only if you carry a balance into the next month’s cycle.
But, if you cannot pay the full balance, the interest will begin the first day of the billing cycle.
How much interest will be charged exactly?
Well, it depends on a few things: Your average daily balance, your APR (you find this on your statement, terms, and conditions, or online account), and if you make any new charges or payments.
Let’s look at an example.
For this learning exercise, we will use a balance of $500 and a 19.99% APR.
Let’s assume that you have decided not to use your credit card because you want to pay it off.
First, you’ll need to calculate the daily periodic interest rate. APR / 365 days = DPR
In this case.19.99/365= 0.0547671233%
Now, to calculate your interest, use the formula: Average daily balance x Amount of days in the billing cycle x Daily Periodic Rate = Interest charged
In this case,$500 x 31 x 0.000547671233 = $8.49
So, you would be charged $8.49 in interest on your next statement assuming you didn’t make any new charges or payments.
But, if you actually use your credit card, your spending might look like this:
- Day 1- $500 balance
- Day 5- Charged $48 to eat out
- Day 13- Bought kids summer toys $38.45 charge
- Day 17- Charged $39.75 for take out dinner
- Day 25- Charged $49.01 for gas
- Day 28- Payment due, made a $200 payment
The first thing you need to do is calculate your average daily balance. Since you’ve made charges and payments, it won’t be $500 all month as the last example.
To do this you’ll need to find your balance for EACH DAY, then divide it by the number of days in the billing cycle.
So…
- $500 x 4 days = $2000
- $548 x 8 days = $4384
- $586.45 x 4 days = $2345.80
- $626.20 x 9 days = $5635.80
- $675.21 x 3 days = $2025.63
- $475.21 x 4 days = $1900.84
- Total=$18,292.07
$18,292.07 / 31 = $590.07 Average daily balance
Now, using the same formula as before: Average daily balance x Amount of days in the billing cycle x Daily Periodic Rate = Interest charged
We get: $590.07 x 31 x 0.000547671233 = $10.02
You will be charged $10.02 in interest on your next statement.
This is how credit cards work.
A few things to keep in mind…
If you can bring down your average, hence make charges at the end of your billing cycle, the amount of interest charged will be less.
Now, you can calculate the interest ahead of time to plan.
If you don’t make another payment because there was an emergency, you’ll be charged on your remaining balance, which includes the interest. So basically, you will be paying interest on interest.
Related: Why You Need An Emergency Fund Before You Pay Off Debt
What is the Grace Period
Before we go into grace periods, I want you to understand the billing cycle. Contrary to what you may believe about a monthly billing cycle. The billing cycle does not start on the first of the month and end on the last day of the month.
So don’t go and add up all of your transactions at the beginning of August to the end of August to try to figure out your payment, it won’t work that way.
Take a look at your statement, it will tell you the end statement date. That is the date that your credit card issuer will add up all of your transactions and determine how much to charge you.
From that date, you have 21 days to pay your bill without incurring interest or late fee charges. This is called the grace period.
By law, your credit card statement must be available to you no later than 21 days before the due date. This will give you sufficient time to know exactly how much you’ll need to pay and by when.
When you pay the entire balance within that grace period, you won’t incur any interest or late fees. Your credit card just loaned you money for free.
This only applies IF you do not have a balance from the previous billing period.
Let’s look at the example in the image above.
Your billing cycle starts on August 6th and ends September 5th. Your payment due date is September 26th. If you make a purchase on 7th, you will have 51 days to pay it off. Pretty cool, right?
Knowing when to make a purchase in your billing cycle gives you the advantage of giving yourself more time to pay off a debt if you know you won’t have the money right away.
Related: How to Create Your First Zero-Based Budget
What Happens if I Pay Only the Minimum Balance
Depending on how your minimum payment is calculated, it may or may not include the interest. If your minimum payment includes the interest, you can slowly get ahead on your credit card debt. The progress you make is determined by your ending balance.
If your minimum balance does not include your interest charges, that amount is tacked on to the balance for the next billing cycle and you will be charged on the total balance.
You will be paying interest on interest. It’s a crappy cycle and it’s why I highly recommend you pay your credit cards in full each month.
Related: This Budget Method is Making People Revamp the Way They Manage Their Money
How Can I Pay Off My Credit Card Faster
You might be thinking, just throw more money at it! Well yes, but if you just throw $50 here and there to any credit card, you won’t get very far.
What happens when you throw $50 at a credit card that just charged you $49 in interest? You just paid $1 towards that card.
You need a plan.
There are two best methods to pay off your credit cards: The Debt Snowball and the Debt Avalanche.
Debt Snowball
- Step 1: List all debts in order from smallest balance to largest balance
- Step 2: Find extra money in your budget by paying the minimum balance on everything EXCEPT the smallest debt
- Step 3: Apply all extra money towards the smallest balance card
- Step 4: After the smallest balance is paid off, then apply all that money you were paying and add it to the minimum payment of the next debt
- Step 5: Repeat until all debts are paid off
Debt Avalanche
- Step 1: List all debts in order from highest interest rate to lowest rate
- Step 2: Find extra money in your budget by paying the minimum balance on everything EXCEPT the highest interest rate card
- Step 3: Apply all the extra money towards the highest interest rate card
- Step 4: After the highest interest rate card is paid off, apply all that money you were paying and add it to the minimum payment of the next debt
- Step 5: Repeat this process until all debts are paid off
Both of these methods work. The difference is that you’ll end up paying less interest over time with the avalanche method BUT it will take longer to pay off your first debt.
Many people can become discouraged when they don’t pay off a debt for a long time, which is why the Snowball method works for most people.
How Can I Lower My Interest Rate
First, let’s talk about why you would want to lower your interest rate.
Your credit card interest rate can make a difference of hundreds of dollars per year, depending on your balance.
Here’s an example: A $5000 balance with 25% interest rate would equate to $1,223.01 over the course of a year.
If you were able to negotiate your interest rate down to 19%, you will only be charged $968.21 in interest over the course of the year. That’s a savings of $255, or $21,25 per month. Could you use an extra $21??
So how do you lower your interest rate?
You call and ask for one.
Sounds pretty simple right? Sometimes, it is that easy. Many times, it’s not.
Here are some steps to take when asking for a lower interest rate.
1. Know where you stand
know your interest rate, your balance, how much you are willing to negotiate, what you can afford to negotiate, and any cash you have on hand if you have outstanding balances.
2. Improve your own credit history and creditworthiness
Most card issuers won’t help you out if you continually max out credit cards and have an unstable payment history.
Do yourself a favor and make on-time payments for at least 6 months before asking for a rate decrease. Work to improve your credit score in the meantime so that you can have a leg up when calling.
3. Know the competition
Do you know all of those credit card offers you get in the mail? find any that are particularly interesting? Use those terms to negotiate with your current issuer. Particularly those that offer a 0% APR for a certain term.
4. Call your company
Make it known that you are trying to help your family and are on your way to making better decisions.
If you are in a hard bind (like divorce, lay off, lost a job, injury, etc) make it known that you are currently struggling and lower interest rate will help tremendously. Be honest, empathetic, and nice.
These people deal with rude and angry customers all the time so appealing to their better nature might give you a leg up when asking for a decrease.
5. If you don’t get what you want, don’t be afraid to level up and ask to speak with the customer service executive
Many businesses know that it is easier to keep an existing customer than to gain a new one. Explain your situation and your specific needs. Always ask for more so that you can settle for what you wanted in the first place.
Related: How to negotiate your utility bills to save hundreds each year
Understanding how credit cards work can help you make better decisions in your finances. Take the time to learn these basic concepts so that you can manage your credit cards like a boss!
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