Credit cards are a double-edged sword – invaluable if used wisely, devastating if used poorly. The optimum way to use a credit card is to never charge more than you can afford to pay, and pay it off at the end of the month. This way, your only cost for the use of credit is an annual fee, if any – as it's not hard to find credit cards with no annual fee and a decent rewards program.
However, let's assume you are in a situation where you have more in credit card debt than you can pay. Now the interest rate matters, because you will carry a balance.
Balances are typically calculated using one of four methods:
- Average Daily Balance – Calculated from the average of your daily balances over the time period.
- Two-Cycle Average Balance – Same as above, but averaging the daily balances over both the current and previous cycle.
- Previous Balance – The payment is based on the balance at the end of the previous cycle.
- Adjusted Balance – The previous balance minus the payments for the current billing cycle.
The first two methods generally produce lower balances than the latter two.
How can you find out how your balance is calculated? If you still receive a paper statement with your credit card bill, the method of calculating the balance will usually be stated somewhere on the bill (often on the back with other pertinent terms and conditions). If not, you should be able to find a "terms and conditions" section on the credit card issuer's website. Should all else fail, if you call the customer service number on the credit card they should be able to help you find the method.
Your credit card has an APR (Annual Percentage Rate), the interest rate applied to the unpaid balance. However, an APR is not always straightforward. Different APR's may apply for different types of transactions – for example, cash advance APR's are often higher than the APR for standard credit purchases.
Also, APR's may include the annual fee, but will not include other fees such as late payment charges or balance transfer fees. As bad as interest charges may be, there may be other charges on top of them.
And how bad could interest charges be? Here's an example.
Assume an unpaid balance of $2,000 and an APR of 13% (the current fixed-rate APR). A typical minimum payment is around 2% of the balance (in this case, $40). With minimum payments only, it takes a little over 6 years to pay off the debt and costs $896.21 in interest – and this assumes you aren't charging anything else during this time. How likely is that?
There's even worse news – most credit card APR's are variable. The average is 15.4%; many are above 20%. Rates are typically set from an index such as the U.S. Prime Rate, plus the set margin your credit card company adds. Your APR may also vary as a function of your credit score (lower credit score equals higher risk equals higher APR). Finally, once any teaser/introductory rates expire, your rate will rise dramatically. Low introductory fees are often balanced with higher annual fees and penalty costs.
Let's take that unpaid $2,000 balance and try some different scenarios.
If the APR is 20% and you make a minimum $40 monthly payment, it will take you more than 9 years (109 months) to pay it off and you will pay $2,336.04 in interest – more than your balance!
Double that payment to $80 and the repayment period drops all the way to 33 months and a total interest payment of $608.84 – a huge improvement.
Go all the way to $200 repayments and you will pay the balance off in one year with only $206.09 in interest charges.
The bottom line is to pay as much of your credit card debt as you can each month, and never miss a monthly payment, even if all you can afford to pay is the minimum. Those two steps have the greatest impact on your ability to get out of debt than anything else you can do.
If you want more credit, check out MoneyTips' list of credit card offers.