This is part 1 of a 2 part series. Part 1 explains how credit card companies charge interest and stresses the importance of APR. Make sure to check out part 2, which goes into detail about getting rid of your debt for good – How to Pay Off Credit Card Debt, Part 2
Ah, the credit card. They’re everywhere, everyone has them and almost everyone has debt. But how does that debt happen? It’s usually related to compulsive spending and ignorance associated to interest.
Credit cards are one of the most useful yet one of the most “dangerous” ways to make a monetary transaction. There is nothing really wrong with using credit cards, it’s the people who misuse them that is a problem. However, that isn’t saying that credit card companies are good and honorable, but putting all of the blame on them alone is irresponsible.
Credit cards are nothing more than a plastic card that gives you the ability to purchase goods or services with the intention of paying back the company. Chase buys your groceries at Walmart and then sends you the bill. However, if you don’t pay off that bill, they then have the right to charge you money for the remaining balance. In fact, if you paid off your balance every single month, a credit card can actually become a convenience. There are some that have cash back rewards or other perks and without a monthly balance, you are charged nothing.
But what about those purchases that you can not afford and make anyway, thinking you can afford the monthly payment for 6 months? Perhaps you can afford the monthly payment, but usually it’s addictive. You can afford a higher payment, then buy something else, and it repeats until – snap! I’m in debt! Your situation may not be due to unwanted purchases, but simply had to start using your card to survive after losing a job. The point is, if you have debt, you want it gone.
The problem with financing your purchases with credit cards is interest. Before we move on, I need to explain exactly what interest is.
How to Calculate Credit Card Interest
First things first, how do credit cards make their money? It is primarily made through interest, which is a fee for carrying a balance on your card. I have made a tool for calculating credit card interest and to show how long it will take to pay off your credit card debt, so you don’t have to do it by hand. It will help you to follow along while using it – Credit Card Debt Payoff Calculator.
Let’s say for example you have a credit card that has a $2,000 balance and each month you have been paying the minimum payments. During the month, you did not make any purchases or payments, which would put your average balance at $2,000. This credit card has an APR of 22.49%, which is absurdly high, but very common. Most credit cards require a minimum payment of 3% – 5% of your balance, so $60 if 3%. Each month you’re paying around $60 but the balance never seems to go down, why?
Most credit card companies charge daily accruing interest, but make it hard to understand. This is partly due to giving their members only an APR, which means annual percentage rate. In our example, our APR is 22.49%. So, in order to find how much daily interest you will be charged, first take your APR and divide it by 365:
22.49% / 365 = 0.061616%
Now take this number, and multiple it by your average daily balance for the month (NOTE: Keep in mind that the number you got above is a percentage. You have to move the decimal two places to the left!):
.00061616 * $2,000 = $1.23
So that means you are paying about $1.23 per day. Now multiple this by the number of days in the month:
1.23 * 30 = $36.90
You’re paying $36.90 in interest each month without making any more purchases. Now, your minimum payment was $60. $60 – $36.90 = $23.10 which means for every $60 you are paying on your card, only $23.10 is going to your principal. The extra $36.90 will be going into the pockets of the card company.
It’s very easy to see how this can get out of control very quickly. If someone has more than one card with similar APR and balances, it seems impossible to escape. And without knowing what to do, it is. Just paying your minimum payments each month will never get you out of debt and lead you to paying thousands of dollars more than you should!
In fact, going deeper into our example, let’s see just how long it would take to pay off the credit card by paying only the minimum. (The following example assumes you are paying $60 each month and do not use the card at all.)
By the first year, you have paid a total of $720 but your principle has only gone down $299.87! That means you have lost $420.13 to interest! Your balance is now at $1,700.13. Fast forward to 3 years, that is 36 months of $60 payments for $2160. You have now paid more than your original balance, but your principle has only gone down $1,142.82. So after 3 years, your balance is now at $857.18 and you have paid $1,017.18 in interest. (Just for more number crunching, if you only paid the minimum each month [that is 3% of your balance, rounded to the nearest whole number, at $15 minimum] it would take 158 months [13 years!] to pay off for a total of $2,722.31 in interest.)
It isn’t until 53 months, 4 years and 4 months, that your debt is paid off. In all, you paid $3,180 on your $2,000 balance for an extra $1,180. Yikes! And this is just one example of a $2,000 credit card, if you have multiple credit cards, it is an even bigger mess. According to my 5 second Google search, the average American has $8,000+ in credit card debt. Take my same figures, but with $8k debt instead of $2k (also $240 per month since the minimum payment would go up), and you end up paying a whopping $12,668 over 53 months, an extra $4,668.34. Double yikes.
Why is this useful? The first step is to sit down and figure out what you’re up against. Learn about the interest and understand that minimum payments are a trap. If you have done this, take a step back and give yourself a congratulations. You did not run in fear, you stopped ignoring the issue. You’ve accepted the problem and have taken responsibility. Most people don’t even take this step. However, now comes the hard part, setting up a plan and getting your debt paid off.
Continued here – How to Payoff Credit Card Debt, Part 2