Understand Credit Cards

Using credit cards without fully understanding the relevant money math is a recipe for financial disaster. Credit cards start charging interest the day you make a purchase, take a cash advance, or transfer a balance from another account.

You’re typically charged a daily rate that’s equal to the APR divided by 365 (the 365 days in a year). Rates may be different for each transaction category and depending on your credit rating. For instance, your APR could be 11.99% for new purchases, 23.99% for cash advances, and 5% for balance transfers. Balances accumulate day after day until you pay them off in full.

Finance Tip

When comparing different bank accounts, always compare APY instead of APR to know which one pays more interest on an annual basis.

You can make a monthly minimum payment and carry over the remaining balance from month to month. But that’s not a wise way to manage credit cards because the interest starts racking up. Additionally, if you make a late payment, you’re charged a late fee that gets added to your outstanding balance—and interest is calculated on that amount too.

The bright spot in using a credit card wisely is that you’re given a grace period for new purchases that allows you to avoid all interest charges—if you pay your balance in full by the billing statement due date. Note that there is generally no grace period for cash advances or balance transfers.

FLH-10

Table 2Amortization Schedule

Payment month Loan balance (dollars) Monthly payment (dollars) Interest portion of payment (dollars) Principal portion of payment (dollars)
1 $20,000 $617.54 $116.67 $500.88
2 19,499.12 617.54 113.74 503.80
3 18,995.32 617.54 110.81 506.74
4 18,488.58 617.54 107.85 509.69
5 17,978.89 617.54 104.88 512.67
6 17,466.22 617.54 101.89 515.66
Table 1.4: Table 2 Amortization Schedule

Credit cards are a powerful financial tool that can enhance your life if you use them responsibly. But abusing them by making purchases that you can’t afford to pay off in full each month can be devastating to your financial future. It will also harm your credit report history if you make late payments. You’ll learn more about how to establish and maintain a good credit history in Part 5.

Calculate Credit Card Payoff

Question: If you buy a TV for $2,000 using a credit card that charges 23.99% APR, how long would it take to pay off, if you only make minimum payments of 3% of your outstanding balance down to a minimum of $15 per month?

Answer: It would take over 16 years! So, if you’re 17 years old right now, you’d celebrate your thirty-third birthday before you finally pay off the TV. Due to the high rate of credit card interest, the total cost of the TV would actually be $5,328. That’s an increase of more than 266% on the TV’s original purchase price. Only making minimum payments can easily double or triple the price of any item charged to a credit card, which is why it’s so important to pay off credit card balances in full every month.

Finance Tip

To determine how long it would take to pay off a credit card if you only made the minimum payments, do a web search for “credit card minimum payment calculator” and enter your information.

Amortization

Gradually paying off a debt’s principal and interest in regular installments over time is called amortization. Loans that amortize, such as a car loan or home mortgages, have fixed interest rates and charge equal monthly payments, though each payment is made up of a slightly different amount of principal and interest.

Take a look at Table 2 to see how each payment is split up for the first six months on a three-year $20,000 car loan with an interest rate of 7%:

Notice that each month’s beginning loan balance is reduced by the prior month’s principal portion paid. The interest portion is slightly lower each month because it’s calculated on an ever-decreasing principal balance.