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The average rate of interest on credit card debt is an astronomical 14.1%, according to May 2018 data from the Federal Reserve, the most recent figures available. It’s tough for anybody to get ahead financially with that sort of baggage. Here’s how understanding credit card interest will help you lessen the impact of credit card debt on your finances.

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

The average credit card debt carried by U.S. households in  July 2018 was $8,395. In fact, credit card debt accounts for a very sizable chunk of total revolving consumer debt, which hit nearly $1.04 trillion as of July 2018. Clearly, credit cards are an important part of our day-to-day lives, which is why it’s important to understand the effect of that interest on the total you pay.

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
  • Payment: $60 (3% of remaining balance)
  • Interest: $2,000 x 20% x 12 months = $33.33 [Simple Interest]
  • Principal Repayment: $60 - $33.33 = $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 $4,241 in total over 15 years to absolve the $2,000 in credit card debt. The interest that John pays over the 15 years totals $2,241, higher than the original credit card debt.

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

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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, although it's wise to pay 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% to 20% on a stock portfolio, right? In fact, if you were able to sustain that kind of return over the long term, you would rival investing legends such as Peter Lynch, Warren Buffett, George Soros and value-investing guru Jim Gipson.

Yet, if you received an email with a subject line that screamed, “20% Return Guaranteed!” you’d likely be skeptical. But think about it: There’s at least one guarantee that is ironclad: If your credit card charges 20% interest per year and you pay off the balance, you are guaranteed to save yourself from losing 20%, which, in a way, is the equivalent of making a 20% return.

Ensure Your Investments Aren’t a Guaranteed Drain

Often, however, investors are reluctant to pay down their credit cards and instead choose to put the money in investing or savings accounts. Many factors drive individuals to do this; behavioral finance, which studies biases, or mental shortcuts, that lead to irrational investment decisions, attempts to explain them.

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. (See Understanding Investor Behaviorif you’re interested in knowing more.) Mental accounting sometimes prevents investors from looking at their finances as a whole. Holding a costly credit card balance while using the money for investments actually negates any investment gains you might make. Unless you’re a world-class investor, investing instead of paying off your credit card balance 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 remember, $1 is $1, regardless of whether it is invested or lost. Not thinking this way can be very costly.

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 also your investments will truly grow.

The Bottom Line

The moral of the story: Carrying a balance on your card can be very costly.

Our first recommendation: Pay off your balance entirely. With the astronomical interest rates that credit card companies charge, it simply does not make sense, if you have savings elsewhere, to carry a balance.

If you can’t completely pay off your balance, at least increase your monthly payment, even a little bit. It will be be more profitable in the long run.

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