Understanding Credit Card Interest

By Investopedia Staff AAA

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Did you know that according to an IndexCreditCards.com, as of 2010 the average credit card debt among households with balances was $7,394? Even worse, the average rate of interest on this debt was an astronomical 17-20%. Yikes! It's tough for anybody to get ahead financially with that sort of baggage. This article will shed some light on credit card debt and the benefits of getting out of it.

SEE: Check out our credit card comparison tool and find out which credit card is right for you.

What Is Interest?
Interest, typically expressed as an annual percentage rate, is the fee paid for the privilege of borrowing money. This fee is the price a person pays for the ability to spend money today that would otherwise take time to accumulate. Conversely, if you were lending the money, that fee/interest compensates you for giving up the ability to spend that money today. (If you want a deeper look at the significant factor of time, check out Understanding the Time Value of Money for a quick recap.)

Credit Card Debt
Most of us are familiar with credit cards. As mentioned earlier, U.S. statistics show the average family has long-term credit card debt in excess of $5,000. In fact, credit card debt accounts for a very sizeable chunk of total consumer debt, which hit $2.43 trillion in May 2011. Clearly credit cards are an important part of our day-to-day lives, which is why it's important for consumers to understand the effect of that interest on them.

An Example: Discovering the Benefit of Increasing Your Payments
Let's say John and Jane both have $2,000 debt on their credit cards, which require a minimum payment of 3%, or $10, whichever is higher. Both are strapped for cash, but Jane manages to pay an extra $10 on top of her minimum monthly payments. John pays only the minimum.

Each month John and Jane are charged a 20% annual interest on their cards' outstanding balances. So, when John and Jane make payments, part of those payments go to paying interest and part go to the principal.

Here is the breakdown of the numbers for the first month of John's credit card debt:

  • Principal: $2,000
  • Interest: $33.33 ($2,000 x (1+20%/12))
  • Payment: $60 (3% of remaining balance)
  • Principal Repayment: $26.67
  • Remaining Balance: $1,973.33 ($2,000 - $26.67)

These calculations are done every month until the credit card debt is paid off.

In the end, John pays $4,240 in total over 15 years to absolve the $2,000 in credit card debt. The interest that John pays over the 15 years totals $2,240, higher than the original credit card debt.

john.gif

Because Jane paid an extra $10 a month, she pays a total $3,276 over seven years to absolve the $2,000 in credit card debt. Jane pays a total $1,276 in interest.

jane.gif

The extra $10 a month saves Jane almost $1,000 and cuts her repayment period by more than seven years!

The lesson here is that every little bit counts. Paying twice your minimum or more can drastically cut down the time it takes to pay off the balance, which leads to lower interest charges.
However, as we will see below, it's wise not to pay only your minimum or even just a little more than your minimum. It's best simply not to carry a balance at all.

20% Return Guaranteed?

As an investor, you would be thrilled to get a yearly return of 17-20% on a stock portfolio, right? In fact, if you were able to sustain that kind of return over the long term, you would be rivaling investing legends such as Peter Lynch, Warren Buffett, George Soros and value-investing guru Jim Gipson.

But if someone came up to you on the street or you opened your email inbox and read a headline that screamed, "20% Return Guaranteed!" you'd likely be very, very skeptical. Anyone who guarantees anything is questionable. (For more on how to avoid investment scams check out our Investing Scams Tutorial.)

However, you do get one guarantee by paying off the balance on your credit card: if it charges 20% per year, you are guaranteed to save yourself from losing 20%, which, in a way, is just as good as making a 20% return.

Ensure Your Investments Aren't a Guaranteed Drain
Often, however, investors are reluctant to pay down their credit cards and choose to put the money in investing or savings accounts. Now, there are many factors that drive individuals to do this, which behavioral finance tries to explain. One of these factors is people's tendency to have mental accounts, which causes them to place different meaning on different accounts and on the money held in them. Mental accounting sometimes prevents investors from looking at their finances as a whole. Do remember, $1 is $1, regardless of whether it is invested or lost. Not thinking this way can be very costly. (For further reading, see Understanding Investor Behavior.)

Holding a credit card balance actually negates any investment gains - unless of course you're a world-class investor. Investing instead of paying off your credit card is a guaranteed loss of money.

On the other hand, paying off your credit card debt guarantees you a return, a return of whatever your card charges you. So, if you have money in your investing or savings account, or you have $1,000 burning a hole in your jeans, take that money and pay off your credit card! Then, once you eliminate your high-interest debt, you'll not only have more money (because you're not making interests payments) but your investments will truly grow.

Conclusion
The moral of the story: carrying a balance on your card can be very costly. Our first recommendation is to pay off your balance entirely. Paying the astronomical interest rates that credit card companies charge simply does not make sense if you have savings elsewhere. If you can't completely pay off your balance, increasing your monthly payment, even a little bit, will be very helpful in the long run.

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