By: Sekou Sheriff
RTD CONSULTING
President &CEO
October 5, 2008
Understanding Credit Card Interest
Did you know that according to an Analysis of Federal Reserve Board data, as of 2004 the average credit card debt among
households with balances was $5,219? Now, this does not mean if you have a balance higher or lower than the above stated
amount then you are doing something wrong, it is just the weighted average from the Fed’s statistics. Even worse, the average rate
of interest on this debt was an astronomical 17-20% annually (APR). Yes I know!!!!! It is kind of tough for anyone to get ahead
financially with that sort of baggage. But one thing to remember is that, not all consumers with such balance or APR’s have bad
credit or are mishandling their finances. Some cards, like department stores, are generically high in APR due to lack of credit
history. If you find yourself paying such high interest rate, it is advisable that you consider working on building your credit history or
reducing the amount of debt you carry compare to your income (debt-to-income ratio) before taking on any debt from the credit
market. It is also advisable to at least carry an outstanding balance of about 30% of your credit line. This article will shed some light
on credit card debt and the benefits of getting out of it to help make our community more knowledgeable about our finances.
What Is Interest?
Interest, typically expressed as an annual percentage rate, is the fee paid for the privilege of borrowing money. This fee is the price
a person pays for the ability to spend money today that would otherwise take time to accumulate. Conversely, if you were lending
the money, that fee/interest compensates you for giving up the ability to spend that money today. (If you want a deeper look at the
significant factor of interest rate, check out www.investopedia.com for a quick recap.)
Credit Card Debt
Most of us are familiar with credit cards. As mentioned earlier, U.S. statistics show the average family has long-term credit card debt
in excess of $5,000. In fact, credit card debt accounts for a very sizeable chunk of total consumer debt, which hit $2.5 trillion in 2008.
Clearly credit cards are an important part of our day-to-day lives, which is why it's important for consumers to understand the effect
of that interest on them.
An Example: Discovering the Benefit of Increasing Your Payments
Let's say John and Jane both have $2,000 debt on their credit cards, which require a minimum payment of 3%, or $10, whichever is
higher. Both are strapped for cash, but Jane manages to pay an extra $10 on top of her minimum monthly payments. John pays only
the minimum.
Each month John and Jane are charged a 20% annual interest on their cards' outstanding balances. So, when John and Jane make
payments, parts of those payments go to paying interest and part go to the principal.
Here is the breakdown of the numbers for the first month of John's credit card debt:
• Principal: $2,000
• Interest: $33.33 ($2,000 x (1+20%/12))
• Payment: $60 (3% of remaining balance)
• Principal Repayment: $26.67
• Remaining Balance: $1,973.33 ($2,000 - $26.67)
These calculations are done every month until the credit card debt is paid off.
In the end, John pays $4,240 in total over 15 years to absolve the $2,000 in credit card debt. The interest that John pays over the
15 years totals $2,240, higher than the original credit card debt.
Because Jane paid an extra $10 a month, she pays a total $3,276 over seven years to absolve the $2,000 in credit card debt. Jane
pays a total $1,276 in interest.
The extra $10 a month saves Jane almost $1,000 and cuts her repayment period by more than seven years!
The lesson here is that every little bit counts. Paying twice your minimum or more can drastically cut down the time it takes to pay off
the balance, which leads to lower interest charges.
However, as we will see below, it's wise not to pay only your minimum or even just a little more than your minimum. It's best simply not
to carry a balance at all. If you can afford to pay the card off every month you would save hundreds of dollars in residual finance
charges.
20% Return Guaranteed?
As an investor, you would be thrilled to get a yearly return of 17-20% on a stock portfolio, right? In fact, if you were able to sustain
that kind of return over the long term, you would be rivaling investing legends such as Peter Lynch, Warren Buffett, George Soros
and value-investing guru Jim Gipson.
But if someone came up to you on the street or you opened your email inbox and read a headline that screamed, "20% Return
Guaranteed!" you'd likely be very, very skeptical. Anyone who guarantees anything is questionable. However, you do get one
guarantee by paying off the balance on your credit card: if it charges 20% per year, you are guaranteed to save yourself from losing
20%, which, in a way, is just as good as making a 20% return! (Yahoo finance; credit card 101)
Holding a credit card balance actually negates any investment gains - unless of course you're a world-class investor. Investing
instead of paying off your credit card is a guaranteed loss of money.
On the other hand, paying off your credit card debt guarantees you a return, a return of whatever your card charges you. So, if you
have money in your investment or savings account, or you have $1,000 burning a hole in your jeans, take that money and pay off
your credit card! Then, once you eliminate your high-interest debt, you'll not only have more money (because you're not making
interests payments) but your investments will truly grow.
Conclusion
The moral of the story: carrying a balance on your card can be very costly. Our first recommendation is to pay off your balance
entirely. Paying the astronomical interest rates that credit card companies charge simply does not make sense if you have savings
elsewhere. If you can't completely pay off your balance, increasing your monthly payment, even a little bit, will be very helpful in the
long run.
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