We all know that credit cards with balances cost the holder high credit card interest rates. This interest is not applied as simple interest. The high percentage credit card interest most credit cards carry is compounded interest. It is calculated in a way that is very unfavorable to the consumer. Compounded interest snowballs. The balance rolls over every month when the statement closes out. This is why making only the minimum payment dooms the consumer to a practically endless cycle of debt. Paying interest on top of old interest as well as on the principal is a recipe for an eternal cycle of debt.
Compare Simple to Compound Interest
Simple Interest v. Compound Interest Example
If a $5000.00 loan carried 10% interest the interest would be $50.00 per month. The interest would be calculated on successive months on the principle only. If the loan were carried for a year and paid off at the end of the year the principle amount left over and due would be $5,600.00. This represents the original $5000.00 minus $50.00 paid for each month it was out.
If the same $5000.00 loan instead carried the same 10% interest as compounded interest the total of principal and interest if monthly payments were required but not made would be calculated as $5,050.00 after the first month. Beginning in the second month interest is calculated for that month on the $5050.00 instead of on $5000.00. In the third month interest is paid on the $5,050.00 plus the interest from the second month. This process is repeated in each successive month. The unpaid interest has become principle from that point until final settlement.
Combating Compound Interest
When the statement is closed out the interest that has accumulated up to that point becomes the same as principal. It changes its status. That interest has now become principal for all intents and purposes. As the new month begins, interest is calculated on the entire amount forwarded from the last statement. This is why it is advisable to make an extra payment as far ahead of the due date as possible if extra funds become available for any reason. When the interim payment is made credit card interest is calculated based on the average daily balance for the month. Each day counts. Don’t wait to pay if you get that tax refund or bonus ahead of the due date!
Credit cards fall within the broader category of “revolving credit”. Banks usually use a specialized FICO credit scoring system designed just for them called the “FICO Bank Score”. This score ranges from 250-900.
Revolving credit is defined as credit without a fixed amount to be paid back every month. Other examples of revolving credit include department store charge cards and gasoline cards. As long as you make at least the minimum payment every month you remain compliant with the terms of your contract. You are free to pay the whole balance to avoid credit card interest or any amount above the minimum if you wish. You must pay at least the minimum by the due date. 44% of credit card users carry balances from month to month. The average credit card user who carries revolving debt from month to month has a total of $6600.00 in credit card debt.
If on the second day of the billing cycle you make a new charge on an account with a balance you are paying interest on the interest for the new charge is calculated on the average daily balance. The average interest on credit cards is 16.8%. This breaks down to 0.047 % per day. If you have a $10,000.00 balance you will pay $141.00 a month in interest. You could cut this in half to $70.50 by paying the balance halfway through the cycle. It always helps to make lesser payments as early as you can.
After timely payments, revolving credit debt to available credit ratio is the single most important component of your credit score. It is very much in your own best interest to keep your balances as low as possible on revolving accounts. Installment accounts always carry high balances in the beginning so there is nothing you can do about that. The installment debt to available credit ratio is less important for credit scoring.
Getting Started with Credit Cards
If you have no revolving credit you should take immediate action to obtain it. If your credit situation is poor you may need to get started with a secured credit card. You may need “training wheels” for a while. Prove your responsibility by following the payment rules to the letter. You will earn the right to a real credit card in due time by being consistent in your payments without exception. A secured credit card is not a prepaid credit card. The distinction is crucial.
Secured Credit Card
- You deposit from $200.00 up and draw against your own funds
- Offered by major credit card companies
- Operates like any other credit card
- Reports to big 3 credit reporting agencies every month
- Helps to build or rebuild credit by establishing a track record of compliance
- Credit limit is the amount you have on deposit
- Paid monthly like any other credit card
- Debt to available credit ratio is the percentage of amount owed when the statement is closed each month in relation to the amount on deposit
Prepaid Credit Card
- Reloadable cards that operate the same way as credit cards
- No bank account or credit check is required
- Does not report to the major credit bureaus
- Does not affect your credit score one way or the other
- Confusing array of fees including activation, monthly maintenance, transactions, ATM, balance inquiries, adding money, inactivity
- Useful only in an emergency temporary way. Provides no help for your credit score or to a better future.
More Credit Card Pointers
It is very important to keep compliant with all revolving and installment debt month after month. Even a single late payment does heavy damage to your credit score defeating the purpose for which you obtained the credit cards.
Starter credit cards are real credit cards. They are low limit credit cards with high interest rates known in the industry as “fee harvester” cards. These cards represent a step up from secured cards. Most credit analysts categorize a FICO score of 680 or less as a “subprime” score. Credit cards issued to people with scores between the high 550s and 680 typically have credit limits of between $300.00-$500.00.
Credit card interest like most personal debts is not tax deductible. Interest on mortgages and student loans are the 2 big exceptions to this rule. If you use your personal credit card for business purposes the interest on that portion of the interest assessed on the business debt is tax deductible. It is best to get a separate business credit card for charges related to your trade or business activity as soon as you can.