How Credit Card Interest Really Works

Not in your favor, I can tell you that.

Neon “Ouf!” sign by T on Unsplash

You’re to be forgiven if your attempt to understand credit card interest rates and terms feels a little like this:

GIF from Incredibles: “Why would they change math?” via Disney and Giphy

And if I told you that figuring out your credit card rates is no big deal, I’d be lying. That’s particularly true if you’re a serial promotional offer-junkie like me: your statement may have two, three, even four or more different interest rates going. But with a little patience, you can see how it’s done. That’s the first step toward control.

If you take away nothing else from this article, please know this: credit card interest is different from almost every other kind of interest. Why? Because it compounds every day.

Credit Card Interest: The Dark Arts of Compounding

Every sum you borrow or save with a financial institution will carry annual interest. How that interest affects your balance will depend on the credit terms under which you are saving or borrowing. If you (like me) have spent literally decades just throwing away or ignoring your notifications of credit terms, now is the time to stop. Go have a look. Figure out what’s happening to your money.

Most forms of credit — mortgages, student loans, lines of credit like a home equity LOC, auto loans, and personal loans — calculate interest monthly, based on what your average daily balance was. (Student loans actually do calculate daily, but they don’t compound).

Credit cards charge interest daily, on the basis of that day’s balance. If you are carrying a balance for even one day past the 30 day grace period from the moment of purchase, you’ll pay a little bit more interest for that balance each day.

Stop right here and do this: Choose any one of your credit card accounts to learn from. If you get your documentation by mail, and if you kept your agreement, check it now. If not, go online and sign in to your account. Go to your profile and look for information about your account’s annual percentage rate, or APR (on one of my accounts, this was in Account Details).

Once you have the rate in hand, divided it by 365. That’s the daily rate, and it is charged on yesterday’s balance.

So, let’s say you start the month with a balance of $300. Your APR is 15.49%

Divide your APR by 365. You’ll get .04 percent, or .0004.

Now, multiply $300 by that number. You’ll get 12 cents.

Oh, that’s not too bad. For a while, you’re just paying 12 cents a day on top of what you already owe. By the end of the month, you owe $303.90 instead of just $300.

You start the next month with a balance of $303.90, and your daily interest will compound on the same basis.

Carry that balance for a year, and you will pay a little more than $50 for the use of that credit. And if you, like many Americans, are carrying $5,000 or more in credit card debt from month to month, you’re paying $837.51 by the end of the year just for that beginning balance.

Hate forking all that money over? Me too. Luckily, there are some workarounds if your balance is creeping up. Unlike credit card debt, they are simple. Also unlike credit card debt, they are not so easy to slip into. Stay on top of these hacks, or they could actually increase your debt.

Credit Card Interest Workarounds

If you carry a balance on your card, the only part you really need to worry about is the balance you had on Day One of the monthly cycle. If you can pay off this amount in full each month, you can carry a certain amount of debt without paying a penny extra.

I tried it this summer. Until July, it worked like a dream. But if you, like me, have an income that closely matches or is even exceeded by monthly expenses, sooner or later this approach will catch up with you.

Other workarounds are a little more human and labor intensive. Some of them are much less available than they once were, but worth a try.

  • You can try to negotiate a reduction of interest. This works with fewer and few credit card companies now, but if you have an excellent repayment history, you may be able to have your interest shaved down. It’s worth a phone call just to try. Credit Karma has some tips here.
  • You can look into a fixed personal loan. I’ve successfully managed two personal loans to get a handle on credit in the past. I believe they have an advantage over a balance transfer or “charge back” (described below) because the payment is fixed, and you will pay more to principal as the loan ages. One drawback is that as soon as your credit cards are cleared, you have a large balance to pay down and the tempting emptiness of credit cards. It takes enormous discipline, plus the luck of steady expenses without bad surprises, to keep from ratcheting up your debt again. Caveat debitor.
  • You can try a balance transfer. Personally, I have burned myself more times than I care to say on this one, but at the moment we are keeping up with one balance transfer reasonably well. The trick is not to take on too much debt; keep it modest, and payable within 6 months instead of the 12 or 18 they normally give you. Calculate the opportunity cost represented by the 4% or 5% up-front fee they usually charge, and estimate what would happen if you wind up having to pay at full interest for, say, 3 more months. Then, if it still seems like a good deal, go for it.
  • Or do a “charge back” with a lower- or no-interest promotional offer from the same company. I am about to try this with a credit card balance that stands at $500, about what I can repay in 6 months if I take out the same amount from the same card on a promotional offer and then “pay it back” to get the lower rate. I’ll let you know how it goes.

The Best Debt Payment Plan Is No Debt at All

Dollface, don’t get discouraged by this hard truth, but your best bet — and mine, still out of reach at this writing — is to treat your credit card debt as a 30-day loan, nothing more, and pay it off each month.

I managed to do this for exactly two months this year, but that was two more than I’d ever done before, so as the days get shorter and the bargains beckon, I am still more confident than ever that 2020 will be that year, at least for the one little card I’m almost done paying.

You can do it, too. Not today, and maybe not even next year, but soon. Just by understanding the credit interest game a little better, you are on your way.

Don’t lose your nerve!

Say, drop me a line and tell me how your plans are going. I’d love to hear your goals. Keep going — and don’t lose your nerve!

The Traumatized Budget has a newsletter! Want a monthly round-up of tips, tricks, and encouragement to get a grip on your money? Subscribe here.

I’m a 50-something bohemian with a mountain of debt and regrets. Can I dig out before it’s all over? I brake for poets.

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