Credit cards are easy to get, and even easier to spend money with. This is one of the most dangerous features about them for those with bad spending habits though. Here you’ll see the true cost of carrying a balance on your credit card.
The Overview:
Credit cards are integral to modern life. They make it quick, easy, and secure to spend money for everyday purchases. As many first time cardholders find out though, credit cards can often make it a little too easy to spend money. Since you only see your balance at the end of the month, typically, and it can be easy to lose track of small purchases, some new credit card and even experienced credit card users can get into trouble.
Interest rates on credit cards can be incredibly high, usually approaching the legal limit for interest rates in each state (known as the usury limit).
You can learn more about the usury limit in your state by clicking here.
Charging interest on credit card purchases that don’t get paid off at the end of the month is the primary way that credit card issuers make money. It’s also how they pay for those perks that cardholders enjoy. So, you want to be one of the cardholders that enjoys the perks, not one of the cardholders that pays for them.
Even small purchases can add up quickly using a credit card. That’s not to mention that many Americans rely on credit cards for emergencies. It’s a simple fix to pay for a new set of tires or a last minute flight with a credit card. Unfortunately, when these purchases aren’t paid for at the end of the month, the interest can really add up.
Due to the compounding nature of the interest charged on credit card balances, the interest can also be applied on interest that was unpaid from last month. This can make credit card balances spiral quickly out of control.
“I’m a financially savvy person, but got into a habit of living beyond my means. I felt like I had to keep up appearances, but I couldn’t afford to do so. My credit card balances just kept rising every month. It got to the point where I was paying the equivalent of my car payment in credit card interest every month. That was really a wake-up call.” -LWB, California
The Math:
Let’s assume that you have a credit card that gets $500 of purchases on it each month. You can afford to pay $500 each month to pay the balance, but you can’t afford to pay any more than that. You get into a car accident and have to pay $1,000 for repairs. Life goes on, however, so you continue to spend $500 per month on the card, and can only afford to pay $500 of the bill each month. Now you’ve got a balance of $1,000 on your credit card that is accruing interest. Since you can’t afford to pay more than $500 each month, let’s assume that you only pay the minimum you can against the $1,000. That means that each month, you’re stretching to afford to pay $500 plus around $30 per month as the minimum against the $1,000. If you continue like that, and assuming a normal credit card’s interest rate of 18.99%, you’ll pay $546.53 in interest on the $1,000. Furthermore, it’ll take you 61 months, or just over 5 years, to pay off the balance.
Yes, it’s that bad. On even small purchases, you’ll rack up massive interest – in our example, you’d be paying over 150% of the original purchase price and it would take literally years to pay off. Isn’t that crazy!?
Conclusion:
Hopefully that simple math problem makes it clear why credit card balances are incredibly dangerous. Imagine how quickly it can get untenable to even make the minimum payments if something like a loss of a job, or a more expensive emergency arises. So, make sure you’re living within your means – just because you can buy something, doesn’t mean you should!
Technical Discussion on how to calculate interest on credit cards:
There are a few different methods used to calculate the interest you’ll owe on credit card purchases. Review your credit card agreement for the method your card company will use.
1. The Average Daily Balance (ADB) Method
This is the most commonly used way that credit card companies calculate the monthly interest you owe on your credit card. The ADB method is used because months don’t have a set number of days (February has 28 days, but March has 31 days, for example). The ADB method starts with calculating the “Daily Periodic Rate” (DPR) by dividing the Annual Periodic Rate (APR) by 365 days in a year.
To then calculate the Average Daily Balance, add up all the daily balances in the billing cycle and then divide by total days in the billing cycle. This produces the average of the daily balances.
Average Daily Balance (ADB) = Sum (Day 1, Day 2, …, Last billing cycle daily balance)/total number of days in the billing cycle.
Next, multiply the Average Daily Balance (ADB) by the Daily Periodic Rate (DPR) to produce the average interest you owe for each day. Next, just multiply that by the number of days in the billing cycle to get the total interest for the billing cycle.
Monthly interest payment = ADB x DPR x (Number of days in the billing cycle)
Example: Sally is going on a trip and wants to make sure she can afford it with the interest she’ll be charged by her credit card that month. Sally’s credit card has an 18% APR interest rate. First, we’ll calculate the Daily Periodic Rate as follows:
DPR = 0.18/365 = 0.00049
If Sally has a $5000 balance, but made a minimum payment of $250 half way through her billing cycle and this was a month with 31 days, she would have an Average Daily Balance calculated as follows.
ADB = (15 × 5000 + 15 × 4750)/31
So Sally’s ADB = $4717.74
Next, we multiply the ADB, the DPR, and number of days in billing cycle (31) to find the monthly interest payment:
Monthly interest payment = $459.68 x 0.00049 x 31 = $71.66
Sally’s interest payment for the month will be $71.66.
While the ADB method is most common, credit card companies have two other common ways of calculating monthly interest payments.
The Previous Balance Method
Multiply the DPR by the previous month’s balance. Then multiply by the number of days in the billing cycle. If Sally’s balance at the end of the previous month was $5000, the math would look like this:
Monthly interest payment = 0.00049 x 5000 x 31 = $75.95
Adjusted Balance Method
First find the Adjusted Balance by taking the previous month’s balance and subtracting payments made. Then multiply the DPR by the adjusted balance and the number of days in the billing cycle. With Sally’s $5000 balance that she made a $250 payment on, you’d get the following result:
Monthly interest payment = 0.00049 x (5000 – 250) × 31 = $72.15
When credit card companies calculate the minimum monthly payment, the payment is mostly interest with a little principal. This is why it take so long to pay off credit cards that are only being paid with the minimum payment.