Chapter 2: Credit Cards – An Owner’s Manual
Interest – Paying & Avoiding
While paying your credit card statement in full each month provides you all of the advantages of being a credit card holder (fraud protection, buffer of time between spending and payment, points/rewards, etc) and avoids all of the disadvantages (interest, late fees, growing balances), the vast majority of credit card accounts are not paid in full each month. Most cardholders carry a balance from one month to the next on at least one credit card. And frequently on multiple cards.
Let’s be clear: when I refer to carrying a balance
I’m really saying you’re in debt.
This is not a judgment thing. You’re not lazy or a bad person for carrying a balance. Carrying a balance (in my eyes at least — I can’t speak for Uncle Dave or Aunt Suze) is not a reflection on your character nor your intelligence. But, like the fees we discussed earlier, interest is expensive and it can be avoided.
At this point, you’ve likely got one of three responses.
- “So what if I carry a balance from month to month. It’s not all that much. What’s the big deal?”
- “Wait, someone told me that the best way to build my credit is to leave a small unpaid balance on my card each month.”
- “I know I’m in debt and I hate it but I just don’t see a way out of this cycle.”
Addressing those three hypothetical (but very realistic, from past experience) responses in reverse order:
- I hear you. You’re not alone. Unfortunately, though, that issue is outside the scope of this guide. You might want to consider working with a professional who can help. I can recommend a money coach 😉. Seriously though, I’ve helped clients climb out of some pretty ugly debt situations.
- I dread this one and, frankly, I’m disgusted with how often I hear it. This information is intentionally misleading. I consider it financial malpractice. It serves no one but the bank. As I discussed earlier in Section 2.2 – Balances, if you pay any less than your statement balance your bank can charge you interest. And not just on the carried balance, but on all new charges too. I’ve had clients who could have easily paid off their balances and kept their cards paid in full each month but they followed someone’s misguided or misleading advice — the result being years of completely unnecessary compounded interest. And the worst part of it is: carried balances, in and of themselves, have no impact on your Credit Score. [More on this coming up in Section 3.3 – Improving Your Credit Score.]
- I’m so glad you asked that question. Let me tell you why carrying a balance is a “big deal.”
The single most important thing to understand about credit card interest is that it is compounding interest. And it compounds daily. That means that every single day your card has a carried balance, your credit card company is charging you interest. And each day they take that new interest charge and tack it on to your principal so that tomorrow you’ll be paying interest on a higher balance.
Using my visualization method again, here’s what that looks like:
Day 1: Principal x Interest = Principal(1) Day 2: Principal(1) x Interest = Principal(2) Day 3: Principal(2) x Interest = Principal(3)
Let’s add some numbers* and see this illustrated more clearly:
Day 1: $800 x 0.04658% = $800.37 Day 2: $800.37 x 0.04658%= $800.75 Day 3: … = $801.12 *** Day 30: … = $811.25
*I used 17% APR (or a .04658% DPR) for this example based on Experian data.
Please note, in my scenario above you have not added anything to your credit card balance—no new purchases, etc. That’s just your current balance silently compounding for 30 days between your payment and your next due date.
Let’s play this out a little further: your beginning carried balance was $800.00. After 30 days of compounding interest, your new statement balance (remember, you’ve added no new charges to your card) will be $811.25. If you were to make a $25 minimum payment on Day 30, the first $11.25 of your payment goes toward interest and only $13.75 would go toward paying off your principal. Your new principal would be $786.25 and the cycle would begin again.
By the end of month 2, again adding no additional charges but with interest being compounded daily, your statement balance would be back up to $797.31. Sixty days ago you owed $800, you haven’t made any new charges to this card, you sent in a $25.00 payment, and still, you owe only $2.69 less than you did 2 months ago. That’s like trying to swim upstream.
Playing this scenario out even further (using Bankrate’s calculators): with an $800 initial balance (fixed, nothing added other than interest) paid off over time making $25 monthly payments, it would take 3 years and 7 months to pay off the debt and you would have paid a total of $273.28 in interest. So that $800.00 initial bill will have ended up costing a total of $1,073.28.
Now imagine the above scenario except your balance is $8,000 instead of $800. If you made only minimum payments (interest + 1% of balance) and never made any additional purchases, it would take over 26 years and you’d pay over $10,700 in interest alone! That’s not swimming upstream, that’s being caught in a riptide.
Freaked out yet? Well, hold on because it actually gets worse.
Compound Interest and the Billing Cycle
Remember that 21-60 day buffer of time created by the billing cycle and grace period? And if your credit card is paid in full each month, that buffer works in your favor, right?
Well that same advantage turns into a huge disadvantage if your account has a carried balance because the extra tricky thing about credit card interest is that it’s calculated based on your account balance, not your statement balance.
Here’s how it works:
Let’s say for some reason, you leave an $800 carried balance when making your payment. You’ll be charged interest on that balance starting on the first day after your due date. And remember, that interest is compounding daily.
So you’ve got an $800 carried balance and then you spend $25 on gas with your credit card. That new charge gets added to your daily balance and starts incurring compounding interest as soon as the transaction clears your account. And this happens with every single purchase you make on your credit card for as long as you have a carried balance.
New charges get added, your account balance grows, and your bank calculates interest based on that new higher balance. Every day.
But wait, we’re not done yet.
Remember, The Banker pays the merchants for all of your purchases for an entire billing cycle. Then, on your closing date, The Banker starts a new sheet, tallies the old one, and sends you a bill. On a PIF card those new charges have been silently and conveniently out-of-sight — something you didn’t have to worry about until you got your next statement.
But now, since your account has a carried balance, all of those new charges have been accruing interest for up to 30 days before you even get a bill. Once you factor in the grace period, it’s possible you will have been assessed as many as 60 days of compounding interest before your payment is processed and applied to your account.
Here’s what that looks like in numbers:
Day 1: $800 x 0.04658% = $800.37 Day 2: $825.76 (new $25 charge + interest) *** Day 30: $836.59 *** Day 59: $847.97 Day 60: $847.97 - $25 = $822.97 x 0.4658% = $823.35
And that’s why banks offer “generous” grace periods.
If you’ve been using your credit card for years and years, adding new charges throughout the month, and never paying off your entire balance and therefore never putting full stop to the compounding interest madness — well, that’s exactly what your credit card company hopes you will do. That’s exactly what so many cardholders do month in and month out, year after year. You could literally still be paying interest on the family’s vacation to Disneyland three years ago or the Valentine’s Day dinner you and your spouse enjoyed last year or the tires you put on your car so long ago that it’s time to think about replacing them again.
Credit card interest can be a sticky trap. By design. Even the smallest carried balance on your credit card will trigger interest. And that interest will be calculated daily based on your current account balance (carried balance plus new transactions plus previous day’s interest). The time buffer created by the billing cycle and grace period that works to your advantage when your statement balance is paid in full suddenly starts working against you if you have a carried balance.
next >> Section 2.4: Cash Advances