It's jarring to open a credit card bill and see that the balance due is more than you charged, but the businesses who extend you credit are in the business to make a profit. They charge interest on what you borrow, a percentage of the amount you owe, and fees as well. This is how they make money.
The principal part of your credit card balance is what you actually charged against the card. It's that dinner out you enjoyed two weeks ago, and the bike you absolutely had to have at the beginning of the month. Maybe you took a cash advance when you were in a jam. The principal portion of your balance is the foundation of your bill.
Introductory Interest Rates
The interest portion of your credit card balance is where things start getting complicated. You often pay a lower rate for the first several months, or even the first year: this is known as an "introductory" APR, or annual percentage rate. Credit card companies make it as attractive as possible for you to accept their card and start making purchases, by offering you this reduced rate. Your APR will typically go much higher after the introductory rate period.
The Impact of Interest
If that dinner you charged cost $200 and if you paid $800 for the bicycle, you've borrowed $1,000. Suppose your card charges 15 percent annually, which is a fairly typical rate. This means that an unpaid balance goes up by about 1.25 percent a month -- your annual percentage rate, divided by 12 months in a year. If you don't pay the company $1,000 during the current billing cycle, you no longer owe them $1,000. You owe about $1,012.50: $1,000 for your purchases and $12.50 in interest, or 1.25 percent of $1,000. If you took a cash advance, it's even worse--the interest rate for these transactions is usually higher.
Depending on which company you use, your credit card company may tack on an annual fee, typically on the order of $75 a year. And yes, the interest rate also applies to this fee. If you're late with your payment or if you go over your credit limit, the company will add on fees for these things as well. In this way, it's possible to go over your credit limit without charging your way past it. If you borrowed that $1,000, and if these purchases maxed out your card, your $12.50 interest would have put you over your credit limit. You then may be dealing with an over-limit fee, as well as interest.
The Minimum Payment Trap
If you think you can pay off your balance by making minimum monthly payments, you might be in for a surprise. Minimum monthly payments are typically calculated at about 2 percent of your balance, but a portion of that 2 percent is going to continue to go toward the interest that your account accrues. For example, your minimum monthly payment on a $1,000 principal balance would be $20, or 2 percent. But remember that your bill goes up $12.50 that first month. Therefore, by making just the minimum monthly payment of $20, you've only paid down your principal by $7.50. It will take a very long time to pay off $1,000 at the rate of $7.50 a month or so.
What to Do
The easiest way to avoid the interest trap is to pay your credit card balance off monthly, as soon as you get the bill. Interest doesn't start accumulating until the next billing cycle. If you can't swing that, it's best to make more than the minimum monthly payments. The more you pay, the more you whittle down the balance carrying over from month to month. The lower your balance, the less interest you'll pay.
- A Daily Compound vs. a Semi-annual Compound Savings Account
- How Much Is My Credit Card Balance Costing Me?
- Do Credit Card Companies Charge Interest If You Close the Account with a Balance?
- How Is Interest Calculated for a Mortgage?
- How to Calculate Periodic Interest Over Time
- The Best Way to Pay Off a Debt Interest Balance
- Credit Card Interest Rate Vs. Simple Interest Rate
- How Effective Financing Rates Work