If you’re like us, you open your monthly credit card statements, note the minimum payments required and maybe the interest you’ve been charged and then file them away until a few days before your payments are due.
Credit cards can be great tools
Credit cards can be great tools when used sensibly, They can be very handy when you want to buy something but don’t have enough cash available to pay for it. If you’re typical your access to capital is limited and a credit card represents one way to get an instant line of credit that won’t have many strings attached. Of course, this doesn’t mean the money you can access with a credit card is free. If you’re not certain as to how credit card companies calculate your interest, you may be paying more money than is really necessary. It’s important that you do a good job of managing your credit card spending and that you know the terms of the agreements you have with your credit card providers.
If you’re average
What you may not be paying much attention to if you’re the average credit card user is how credit card interest actually works. Again, if you’re typical, you simply check out the interest you’ve been charged, maybe wince a bit and then move on. But to really understand your credit card bill you need to know how credit card interest really works.
Calculating your credit card interest
If you’ve ever tried to carefully read your agreement with a credit card company, you might come away with the idea that it was written to be almost impossible to understand. This can be especially true when it comes to how interest is calculated. If you don’t know how your interest is calculated, you could end up spending more than you had intended and with a huge interest penalty. Of course, you can prevent these problems simply by paying off your balances in full and on time every month. Unfortunately, many people cannot do this because they need that line of credit to make larger purchases they can’t pay for in just 30 days.
Most credit card issuers compound interest each day. Compounding your interest means that any interest charges you have that accumulate are added to your principal or the total amount you owe. To compound your interest, most credit card companies divide your annual interest rate by 365. The resulting daily interest is then multiplied by the balance of your loan to get the interest you’re charged daily. This is then added to your daily credit card balance.
It’s not compounded monthly
The mistake that most people make is to believe their interest charges are compounded monthly. But as you have read, this is not true for the majority of credit card issuers. This means that if you owe a large amount of money and don’t understand how interest works, this system of compounding can mean that your debt could spin out of control very quickly.
Here’s an example of what I mean. Let’s assume that you owe $1000 on a credit card with an APR or annual interest rate of 15%. If you divide 15% by 365 days, you’ll see your daily interest is 0.041%. This means if you carry that $1000 balance for just one day, your interest charge will be $.41. Then on day two, you’ll be charged that 0.041% on $1000.41. While this may seem kind of insignificant it can become a huge issue if you owe a lot of money. This is the reason why it’s critical that you keep the average balances on your credit cards as low as you possibly can.
When you’re charged interest
A second important question is when will you be charged interest? Unfortunately, the answer to this may not be simple. Many credit cards have introductory offers that give you zero interest for some amount of time – ranging from six to 18 months. As you might guess, if you have a really good credit history you’ll get a longer introductory period. But, of course, nobody will get a 0% interest line of credit forever. After your introductory period expires you’ll be required to begin paying interest on any balance that you carry forward from one month to the next. In most cases, you can pay off your balance at the end of every month and won’t be required to pay any interest. But if you don’t pay off your balance in full, you will start seeing interest charges on your remaining balance.
How your credit card interest rate is determined?
You may understand that your credit card’s APR or interest rate has a big effect on how much you pay in interest each year. But what you might not be aware of is how credit card companies get to that APR. In fact, they use a number of different factors in assigning you an interest rate, including whatever is the prime rate, your credit score, your credit history and any credit card promotions the company is currently offering.
If you’re not familiar with the prime rate it’s based on economic variables tied to the interest rates paid by banks when they borrow from the Federal Reserve on a short-time basis. Generally speaking, the prime rate will be three percentage points higher than the federal rate. This means that when the prime rate goes up banks are required to pay more to borrow from the Federal Reserve and your card’s APR will also increase – probably by the same amount
If you’re like us to open your monthly credit card statements note the minimum payment card or maybe supercharged file them away until a few days famous
The second factor, your credit score, affects how much you can borrow and your interest rate. As you might guess, if you have a high credit score you will get a lower interest rate. And the inverse is true. If you have a low credit score you will pay a higher interest rate.
How you have paid on credit cards and loans in the past also affects your interest rate. For example, if you were to make a late payment, this will directly affect your interest rate. Finally, a credit card company may be offering a promotion as a way to get new customers. Many of these promotions are introductory offers where, as reported above, you pay low or no interest for some period of time.
As a prudent consumer
If you want to be a sensible and prudent consumer, you need to keep abreast of how credit card interest is calculated and how your relationships with your credit card issuers affect your finances. Make sure to read the fine print in a credit card agreement before you sign up for one and understand all its details. That way you won’t have an unpleasant surprise sometime in the future when a credit card statement roles in and you find you’ve been charged an insanely high amount of interest.
Why a credit card can be better than a debit card
There are some very good reasons to have a debit card. For one thing, you can’t run up debt on a debit card. These cards are generally tied to your checking or savings account so that if you completely deplete that account, you can no longer use the debit card. However, there are also some reasons why a credit card can be better than a debit card.
The first of these is that you can build up your credit score with a credit card but not a debit card. When you use a credit card sensibly – especially if you pay off the balance on time every month – this will definitely have a positive affect on your credit score. In comparison, what you do with your debit card will have no affect on it.
Budgeting can also be easier with a credit card as all your transactions will show up on your statement at the end of every month. Good budgeting begins with tracking your spending so that you’ll know where your money’s gone. A credit card statement will help you understand this and see those areas where you might be able to reduce your spending.
Third, debit cards do not come with rewards as credit cards do. When you choose a credit card that comes with great rewards such as miles or cash back, this will help you get more bang out of every buck you spend.
Finally, credit cards give you more protection as a consumer than do debit cards. With most cards, your liability is capped at $50 if someone steals your identity or misappropriates your card. While debit cards do offer protection against fraud it could be as many as two months before you get back the money that was stolen.
