What You Absolutely Need to Know About Credit Cards

Whether you are in the process of getting your first credit card or are a seasoned swiper, there are some things that you need to know about your plastic.

The Numbers

  • Average individual credit card debt: $15,863
  • $901 billion in credit card debt in America (nerdwallet)
  • Average debt per household $7,421 (nerdwallet)
  • Average APR is 14.9% (creditcards.com)

Not all Credit Cards are Created Equal

There are a variety of credit card types. They are:

  • Standard credit cards
  • Prepaid credit cards
  • Secured credit cards
  • Unsecured credit cards
  • Balance Transfer credit cards
  • Rewards credit cards
  • Student credit cards
  • Charge credit cards
  • Subprime credit cards
  • Business credit cards
  • Limited Purpose credit cards

There Can Be Fees

Above and beyond the APR finance charge, some credit cards will have additional fees that will be added to your balance:

  • Annual Fee
  • Balance Transfer Fee
  • Late Payment Fee
  • Over-the-limit Fee
  • Cash Advance Fee
  • Foreign Transaction Fee
  • Returned Payment Fee

Breaking down the APR

An Annual Percentage Rate is a finance charge that is applied to the balance on your credit card. It is essentially a rate of interest over the course of a year. The percentage will change from card to card as well as on the types of transactions on a single card. Once you have a balance on your credit card it becomes subject to that interest rate that the bank has set on that particular card.

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Types of APRs

Fixed — as the name suggests, your interest rate remains constant and is not affected by changes in the Prime Rate. It can however be adjusted by the card issuer as a result of market changes and your credit use habits.

Variable — your interest rate will change according to an index. Most variable APRs are a combination of a rate set by the Federal Government—the US Prime Rate—and a margin that is set by a bank or lending institution. In most cases, you will be notified of an APR change 45 days in advance.

One Card, Many APRs

You may not be aware of this, but you may have different APRs on the same credit card. Depending on why you have used the card for, you will be charged a different rate. Things that will affect an APR:

  • Balance transfer
  • Cash Advance
  • Penalty
  • Purchase of goods or services

How Your Account Balance is Calculated

As your balance can constantly change, there are two methods of determining what the actual amount your APR will then be applied to:

  • Average daily balance—more commonly used, each month’s daily balance is added up and then divided by the number of days in that particular month.
  • Adjusted balance—the previous month’s balance is subtracted from the total and then the interest charges are based on the remaining balance

It will be on your statement. So look for how you will be charged.

Beating the APR

It can be done. But it means paying off the full balance on your card on or before the date that the payment is due. Carry small balances, or balances that you you know you will be able to pay back in the allotted amount of time.

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Important Note: YOUR APR IS APPROXIMATE. A 15% APR INTEREST WILL ACTUALLY BE OVER 16% AT THE END OF THE YEAR.

How the APR is Calculated

Compound Interest

It means that the interest is added to the balance of the amount you owe every month to create the balance that you will be charged interest on for the following month. Let’s take a look example.

You have a credit card whose APR is 15% (which is close to the average according to creditcards.com).

You spend $1,000 on it. Your first month’s interest charge will be $1000 x (0.15/12months) = $12.50. This is then added to your balance to make your first month’s payment $1,000 + $12.50 = $1,012.50.

Your second month’s interest charge is then calculated using your first month’s balance ($1,012.50 x 0.0125 = $12.66). Your new balance is now $1,012.50 + $12.66 = $1,025.16.

This chart shows how the interest compounds.

Month Interest (Month) Interest (Total) Balance
1 $12.50 $12.50 $1012.50
2 $12.66 $25.16 1025.16$
3 $12.81 $37.97 $1037.97
4 $12.97 $50.95 $1050.95
5 $13.14 $64.08 $1064.08
6 $13.30 $77.38 $1077.38
7 $13.47 $90.85 $1090.85
8 $13.64 $104.49 $1104.49
9 $13.81 $118.29 $1118.29
10 $13.98 $132.27 $1132.27
11 $14.15 $146.42 $1146.42
12 $14.33 $160.75 $1160.75

Daily Compound Interest

Rather than pay interest on a monthly basis, many cards charge daily compound interest. This is not to say that you will be charged 15% on a daily basis, but rather an daily equivalent of it. Your APR divided by 365 gives you your Daily Periodic Rate

15% ÷ 365 = 0.00041%

This Daily Periodic Rate (DPR) is then used to calculate your interest per month on your credit card balances.

(DPR x Days in calendar month) x Balance = Interest

(0.00041% x 31) x $1000 = $1,012.73

The cost of borrowing the $1,000 is $12.73 per month.

Minimum Payments = Maximum Interest

If you get into the habit of paying the minimum payment, you will be paying more of the interest off and less of the principal balance. So not only will it take much longer to pay off your debt, but you will pay more in interest to the bank or company that issued the card.

If you have a balance of $1,000 with an APR of 15% and you make monthly payments of $15 you will pay $1,164 in interest before you pay that balance off.

How Long Will it Take to Pay Back

That is entirely up to you. Credit cards can be helpful tools, but when left unmanaged or used beyond the owner’s capabilities, they can saddle the user with a mountain of debt.

If you are interested in knowing when you will pay off a credit card, CNN Money offers a tool that helps to determine how long it will take you to pay back the money owed on your credit card according to how much you owe, how much you are paying each month and the APR on your card. It is an eye-opening exercise.

There are Bonuses

That’s not to say that there aren’t perks to using a credit card. Smart shoppers can use purchases to build up points that can then be redeemed from things like free hotel rooms and airline trips. Sadly, though, most people are unaware of exactly how to get points most effectively, how they work and what they are. But be advised, rewards cards will sometimes charge an additional annual fee.

The Simple Dollar has everything you need to know about rewards cards and then a little bit more. From the best rewards cards to have all the way down to saving money by maximizing rewards, this article covers it all.

Paying on Time

Miss your credit card payment at your own peril. Pay before or on the day that your bill is due. Not paying when your repayment is due is the quickest way to slip into the highest APR bracket. In some cases it can be as high as 30%!

Affect on your Credit Rating

Almost a third (30%) of your FICO Score is calculated by the size of your debt. The closer you are to the maximums on your credit card the more your credit rating is affected. As your balances get higher your score takes more of a hit.

Beware the Promotional Offer

Zero percent interest is almost too good of an offer to pass up. So many people don’t. If you are confident that you will be able to pay off the balance in the allotted time, these offers can be helpful. Be aware of what the APR is once the offer ends and if there are any additional fees, because after the introductory period ends (usually between 6-12 months), you will be subject this charge.

 

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