hIn the first part of this post, Joys and Woes of Credit Cards, we identified some of the benefits and dangers of these little pieces of plastic, but we deferred discussing three “dangers” to this post:

  • They are the most expensive form of credit
  • Interest calculations are not easily followed
  • The illusion of minimum payments 

Before beginning, we’d like to remind you that we genuinely believe credit cards are an important financial innovation. They just need to be used responsibly, and the first step towards this is ensuring you properly understand how they work and could impact you. With this knowledge, you can then make informed, eyes-wide-open decisions.

To illustrate the points in this post, we got statements from a couple local financial institutions and referred to these as needed below. There may be more information in a full credit card lending contract, but the information provided on the statement is what card holders usually assume is the most important. It should also be noted that card providers usually have a fairly extensive menu of card types with different features, but the basic terms tend to be similar from card to card.

Most expensive form of credit

Credit cards offer unbelievable flexibility of use (no wonder they are so popular), but they are likely the most expensive form of credit.

Interest rate

We often ask people what interest rate they are charged on their card, and quite astonishingly, most do not know beyond a general comment that it is “high”.

If you have a credit card, please go now and look for your statement. Somewhere on the first page look for the interest rate. You will probably see a description called either “Monthly Interest Rate” or “Annual Percentage Rate (APR)”.

  • Firstly, if a monthly rate is quoted, it is probably around 2%. But not many people mentally register what 2% monthly means. It is not similar to a rate quote that you’ll hear for a mortgage (e.g. 7%) or personal loan (e.g. 12%) because those loans are quoted as an annual rate. For credit cards, quoting a monthly rate means you need to multiply by 12 to get an approximate annual rate i.e. 2% per month is approximately 24% a year. Notice we said “approximately” because the exact calculation is higher than 24%.
  • Secondly, let’s not worry about what APR means; we’ll do a post to explain it in the future. For this purpose, just think of it as an annual rate. The percentage you see on your statement is likely 24% or 25%. (Update: see the post APR – The True Cost of a Loan.)

Right now, just focus on the number. Can we let it sink in for a moment? 25% on credit card debt…

Out of curiosity, how much do you currently earn on your deposit accounts? Probably less than 1% if you have a simple savings account at a bank. So you earn less than 1% and pay nearly 25%…Does this make any sense?

Please note, we are not trying to assess whether 25% is a fair rate or not. These are complicated products and a lender has a right to charge whatever rate is needed to earn a return for the risk they assume. Instead, we are focusing on YOU. Why on earth would you want to pay 25% on a loan? If you walked into a lender to ask for a loan and they told you it will cost 25%, most likely you’d just walk out. But yet, we accept it on credit card debt. 

We probably accept the ridiculously high rate for two reasons:

  • Firstly, we are just so happy to have easy access to credit that we just don’t think how expensive it truly is.
  • Secondly, when compared to other types of loans, the payment amount the lender requires for credit cards is smaller, which makes it more affordable from a cash flow perspective. For example a $20,000.00 credit card balance at 25% annual interest could have an approximate minimum payment of $460.00. If this were taken as a personal loan for 3 years, the monthly instalments would be about $800.00. We discuss minimum payments below.

Default rate

Sometimes when you pay late, the lender may charge a “default rate”, which would be HIGHER than the normal rate (can you imagine higher than 25%..?). It was not clear from the statements we reviewed if a default rate would be applied.

It’s probably worth mentioning here that you may sometimes receive a card with a “low interest rate” offer. Be sure you understand if this is a temporary offer – it is most likely for a few months only. Also, if you are not a person who pays off their card in full on time, a “low interest rate” card will ratchet up very quickly if you run a card balance or are late with a payment. Pay attention to the details.

Fees

Credit cards also carry quite a range of fees, which may or may not be clear. Of the statements we reviewed, two were fairly forthcoming and identified several: annual fees, late payment fees, over limit fees, cash advance fee, etc.

Are you sure you know what fees you are being charged? These all get added to your credit card balance and therefore you pay interest on these amounts as well, which we discuss next.

Unclear interest calculations

For most loan types, you can recalculate fairly easily the interest you were charged, but not for credit cards, because of the way a credit card balance is built up. From a review of the statements in our possession, here are the most important points to note.

Transaction date

If you do not pay off your balance in full each month, you are charged interest on each transaction from the date of purchase.

We interpreted this as follows: assume your statement is from 1 July to 31 July, with a payment deadline of 15 August, and you did not pay off your balance in full by 15 August. On 1 August you use your card to buy lunch. Do you realize because you did not pay off your card fully that you are paying interest on that lunch purchase from 1 August? This is because by not paying your card balance in full, you now have a loan facility. Each new purchase is treated as a further increase in your loan, with interest charged from the date of each purchase. So you just borrowed money for lunch, and you now have a very expensive meal!

Compounding

What is especially not clear is how interest is compounded.

The first point is, if you do not pay off your card balance in full, the interest charged is added to the total of your purchases.

Let’s say you have a beginning card balance of $5,000 and you are charged $100 in interest and you pay the minimum balance of $150 (3% of your card balance). You do not make any new transactions for the month. This means next month, your card balance will be $5,000 + $100 – $150 = $4,950. If not fully repaid by the next due date, the interest due will again be added to the outstanding balance. Interest being continuously added to the outstanding balance is referred to as compounding.

Ultimately this approach is more expensive for you.

The example above shows interest being compounded monthly, but what is not clear from the statements we reviewed is if interest is calculated and compounded DAILY. This would make it even more expensive. If any readers are aware of these details, please let us know in the comments below!

Minimum payments

As mentioned in Joys and Woes of Credit Cards, the minimum payment is NOT your lender’s recommendation how much you should pay. Neither is it the required monthly loan instalment, which is what lenders would normally provide you, in a mortage loan for example. A credit card loan does not work like other loans: YOU have to determine the right amount to pay; your lender does not tell you the amount.

The minimum payment is simply the LOWEST payment you can make to keep your card ACTIVE (or more specifically, out of default).

In the samples we reviewed, it was not clear how the minimum payment was calculated, but it was likely either a % of your card balance (usually 2%, 3%, or 4%); or a dollar value amount determined by the lender; or a % of your card balance plus interest and fees. Or who knows, perhaps some other variation of these.

While this would be nice to know with certainty, it probably doesn’t matter too much. The important point is below.

Almost impossible to repay

You may not realize that from a practical point of view it is almost impossible to repay your card balance if you only make the minimum payments.

To be accurate, it could just take a very very long time because most of the payment goes against interest and only a very small portion is used to pay down the actual loan balance.

Let’s use an example to illustrate. Note, these are simplified calculations for illustrative purposes; only your lender can tell you precisely how they calculate the amounts. Also, an easy way to do a quick calculation is to check online for credit card calculators.

Let’s say you have a credit card balance on 1st January of $5,000. You pay interest at 25% per year, and you do not put any new purchases on the card. Earlier we mentioned the minimum payment is usually either 2%, 3%, or 4% of the outstanding balance. Note it could be more, but this is unusual. Also the amount could be a dollar value, but we’ll ignore this scenario to keep it simple. 

If the minimum repayment is 2%, you will actually be charged more in interest than you are paying in principal, so your card balance will then grow instead of decreasing. We assume lenders would not allow this.

If the repayment is 3%, you’ll still be owing about $1,650 in ten years time. If the repayment is 4%, you’ll owe about $500 in ten years time.

The point is, paying the minimum will never be in your favour if you want to get out of credit card debt.

You have to make payments several times higher than the minimum. Use our Cari$ Loan Calculators to help you figure out the payment you need.

Lenders love you

It is probably worth considering that if you usually make the minimum payments and incur the occasional late or over-limit fee, you are a dream customer for a lender. The reality is they don’t need you to repay in full; they prefer if you pay just enough (not too much either) to keep your balance moving up and down. The sure sign is when you get offered or are given a limit increase!

Suggestions

If you are carrying a card balance and are not able to pay it off in the near future, try these tips to minimize the impact on your finances and regain control.

  1. The first step is to STOP using your card. Do not add new purchases to the card balance, otherwise you will keep incurring interest on each new transaction.
  2. Do not use a credit card to withdraw cash. If this is truly your last resort, try to avoid the immediate fee and possible punitive interest charge by paying for something for a friend or family member with your card, and let them give you the cash.
  3. Do not wait until the due date to make a payment. If you are able to, make your payment EARLIER than the due date. It will save you an expensive interest cost.
  4. It does not make sense to have cash savings and a credit card balance. We understand the unwillingness to deplete your savings, but the wisest financial move is to immediately pay down your card balance, then rebuild your cash savings by putting away the amounts you would have paid on your card. Be disciplined.
  5. Never pay only the minimum balance. Pay several times more if you really want to bring down the balance.

Closing thought

We once heard the expression that credit cards are not for credit (meaning you should use them, but never create a loan balance). This is a very wise statement…

We hope you found the post helpful. We’d love to hear your thoughts or questions in the comments below!

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Hi. I hope you enjoy reading the posts! I have 20 years regional and international experience in financial services, and I am passionate about helping others achieve Financial Freedom by making wise financial decisions. Keep coming back!

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4 thoughts on “Understanding Credit Card Debt

  • September 13, 2014 at 7:40 pm
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    This was an excellent article. Unfortunately I found myself learning the hard way… excellent suggestions. Thanks caridollarsandsense!!!

    Reply
    • September 13, 2014 at 7:54 pm
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      Hi Indira. Thanks a lot for the feedback! Hopefully the information and suggestions will be able to help others make informed decisions about their cards. Looking forward to your thoughts on our other posts!

      Reply
  • September 12, 2014 at 12:26 pm
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    This was really really helpful, I thought I knew how to manage my card balance but it only put me in further debt. I also did not want to deplete my cash savings and sometimes paid the min. bal. on my card but it does make sense as you suggested to sacrifice and pay off the card balance first Thank you.

    Reply
    • September 12, 2014 at 4:43 pm
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      Hi Kyzier. Thanks for writing and sharing your experiences. Glad the post helped! Enjoy sleeping stress free knowing that you made the right decision! Stay in touch.

      Reply

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