By learning how your credit card interest works, you’re in a position to save a significant amount of money, avoid some of the various debt traps and leverage your credit cards to work for you rather than against you.
A Habitual Practice That Keeps You Out of Debt
One method for staying out of debt and successfully using a credit card is to pay it back more than once per month. Even making weekly payments will decrease the amount of your balance and lower your overall interest as well as keep your credit utilization within acceptable limits. So, fewer dollars spent on interest is an excellent way to save money.
One of Many Reasons Credit Card Interest Exists
When you use your credit card to buy something, you’re borrowing money from your card issuer. When you borrow money, there’s always a cost to you, i.e. the interest you pay on your balance. The established cost of borrowing funds is known as APR (Annual Percentage Rate), and your APR is basically determined by how you rate as a borrower to the person to whom you owe money; in this case, the banks. Your credit score plays a significant part in determining your APR.
If you have a good credit score, you’ll generally get charged a lower APR.
If you have a poor credit score, you’ll generally get charged a higher APR (or possibly not be approved at all).
Grace Period: The Time You Can Use Your Credit Card Without Paying for It
If you pay your entire statement balance by the due date on your credit card, you generally will not be charged interest on your balance and, therefore, the APR is not that significant.
Once you carry a balance past the payment deadline, then the interest engine will turn on and will not be able to slow down.
Interest Becomes Really High
When you carry a balance over what is due, the account will begin accruing interest on a daily basis; therefore when the interest starts to compound on itself you can expect several instances where you have increased your overall amount owed due to interest becoming compounded on itself.
Once you do not make the complete payment by the due date and you miss the grace period to make your payment your future purchases may begin accruing interest right after you use your card; as a result you will find that your future balances will grow at an unexpected rate.
The mathematical side of this is that there are many companies that use an average daily balance method of calculating interest on your account where instead of charging you interest once a month they calculate all of your daily balances combine, divide by 365 days, to get your Average Daily Balance, then they apply the daily rate to calculate the interest that you incurred.
In terms of a tangible example, if you use your credit card and reach your maximum balance by mid-month but you only reduce your account balance at the end of the month, then your Average Daily Balance will be higher than, and therefore charge you more interest than making a payment before you reach your maximum credit limit.
Timing is more important than most people think!
There Are Different Types Of Transactions
Most people do not realize that cash advances and balance transfers come with higher interest rates, and they typically have little to no grace period. Meaning, you may start paying interest immediately on this type of transaction and add fees at lightning speed.
Before using your cash advance or balance transfer, check the terms to help avoid an unexpected bill.
Three Ways To Reduce Interest
- Always make all of your payments on time and in full (if possible). This will guarantee you never pay interest on any type of transaction using your credit card.
- Only charge items you planned for and can afford to pay. Use your credit card as a debit card; it is not free money, it’s money delayed.
- Pay your credit card several times throughout the month. Paying down your average daily balance will reduce the amount of interest you incur.
While interest on credit cards may sound boring, it is actually one of the largest influences in your overall financial situation. When you learn how to calculate interest, along with understanding when interest accrues, you will become empowered and take charge of your financial future instead of guessing it.
Using credit cards should not be based on fear; they should be used intentionally.
