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How credit card interest really works


Have you always hesitated to get a credit card because of fear of going into debt?


Understanding the fees and interest rates associated with credit cards will help you make smarter choices.

To make it easier to compare different cards, it is important to look at these four keywords and their definitions:


  • Annual fees are one-time charges that apply when you open your credit card account. This is a yearly fixed cost usually. Most credit card companies will charge between $50 - $600 per year, depending on the rewards each card comes with.

  • Balance transfer fees are charged when you move a balance from one credit card to another.

  • Annual percentage rate (APR) or annual interest rate stands for charges applied to any unpaid balances on your credit card. This is the most tricky of all of them, as the fees multiply with the increase of your balance. Remember, this is what you borrowed. It is like taking a loan from the bank each month.

  • Minimum credit card payment is the mandatory amount you need to pay off each month for you to obtain good standing. Some banks allow you to pay as little as 5 % on your balance. But is this ok? No. You should never pay off only this minimum amount, as you will be in so much debt if you continue taking small loans each month and not paying your balance off in full.

This is how interest is applied to your credit card expenditures (aka loans):


Let's say that you spent $2000 with your credit card in December and you decided to pay 5% of the debt, which is $100/month. It would take you 20 months to pay the entire $2000 off without interest, however, credit card companies are not that kind. As your balance increases the more you borrow, the reality is the bank will earn more money from you because they charge you interest for lending you that money- just like the mob used to in the old days (with less blood spilled although lol).


In banking terms, this is called interest on your loan, or APR (annual percentage rate), charged monthly. Because of this, it would now take you 24 months to pay it off completely (Table 1, see below), that is if you do not borrow more money within these 24 months. Credit card companies may charge you between 18% and up to 30% on that loan annually, which equates to 1.5% - 2.5 % monthly. The APR depends on your creditworthiness. The higher your credit score is, the lower this fee will be.


Here is an example breakdown of the interest added to your balance with 1 credit card at Chase bank with an 18% APR:

Time it will take to pay your debt

(in months)


(1)Balance $

(2) Balance with Interest 18 % APR (1.5% monthly) (1)*1.015(1.5%)

(3)Minimum payment $ 5%

(4)Remaining balance $ (2)-(3)

1 (formula)

2000

2000*1.015=2030

100

(2) - (3) =1930

2

1930

1930*1.015= 1958.95

100

1858.95

3

1858.95

1858.95*1.015=

1886.83


100

1786.83

4

1786.83

1786.83*1.015= 1813.63

100

1713.63

5

1713.63

1739.33

100

1639.34

6

1639.34

1663.92

100

1563.93

7

1563.93

1587.38

100

1487.39

8

1487.39

1509.69

100

1409.70

9

1409.70

1430.84

100

1330.84

10

1330.84

1350

100

1250.80

11

1250.80

1269.56

100

1169.57

12

1169.57

1187.11

100

1087.11

WITH NO INTEREST

1200

LOSS

112.89

24

PAID OFF IN FULL

Now, imagine you borrow $1000 in addition to the initial $2000 you borrowed on your credit card.

This will increase your balance even more, and it will take you even more years to pay it off.

The moral of this story is - always pay your balance in full. Why should we give banks money that way? Even worse, when you go into credit card debt, your credit score worsens. This means you will not be able to rent or purchase an apartment easily anymore.

By taking into account all three types of fees and understanding how they work, you can make an informed decision about which credit card is right for you.


Conclusion

Using credit cards can help build a credit history, which is important for getting loans or mortgages in the future. In addition, many credit card companies offer rewards in forms of cashback or points, which you can use toward future purchases or savings.


Not paying off your balance in full each month can quickly spiral out of control and lead to unmanageable levels of debt. That is why it is important to understand the interests and how they work so credit card companies don’t make unnecessary profits off of your poor decisions.


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