State of Minnesota
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Attorney General
Lori Swanson

Minnesota Attorney General's Office

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St. Paul, MN 55101

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Chapter 3: The Cost of Credit

The Credit Handbook

Did You Know?

More than two-thirds of cardholders carry a balance from month to month. Cardholders who carry a balance carried an average balance of $3,900 in 1995. New cardholders are likelier to revolve balances and charge more dollars than are veteran cardholders. Also, new users are four times more likely to transfer balances than are longstanding customers.

With 89 percent of Americans using at least one credit card, it's obvious our society is hooked on credit _ but we don't always understand what credit costs us. This chapter will help you learn about credit terms and fees, and figure out what type of credit card is best for you. Get out the calculator! We might be doing a little math.

What Will it Cost Me?

The most important consideration when choosing a credit card is the price. Two major items make up the price of a card _ one is the interest rate (usually called the "annual percentage rate" or APR) and the other is the annual fee. But other fees can add up, too.

Study These Fees

Before selecting a credit card, learn which credit terms and conditions apply. Each affects the overall cost of the credit you will be using. Consider these costs:

  • Annual fees. Many credit issuers charge an annual membership fee. These fees vary quite a bit, ranging from $15 to $75 or more. Remember that not all cards charge an annual fee.
  • Annual Percentage Rate. The annual percentage rate or APR is disclosed to you when you open the account and is noted on each bill you receive. It is a measure of the cost of credit, expressed as a yearly rate. The card issuer also must disclose the "periodic rate." This tells you how the credit issuer figures the finance charge for each billing period.

To get the lowest price, look at both annual fees and interest rates. Ideally you will get a card with no annual fee and a low interest rate. More realistically, look for a card with the best combination for you. For example, if you pay your balance off every month, look for a card with no annual fee. If you make full payment within the grace period each month, you will not be charged interest, so you do not need to be as concerned about the APR. If you regularly carry a balance, you will pay interest and finance charges. In this case you should look for a card with a low interest rate, even if it means paying an annual fee.

A word of warning: most new credit card users plan to always pay off their balance each month, so they don't worry about the APR on their card. Down the road, many of these same people find they don't always pay off their balance in full each month. So, it pays to consider the APR up front, in case you turn into a typical credit card user.

  • Grace period. Also called a "free period," this allows you to avoid finance charges completely by paying your balance in full before the "due date" shown on your bill. If your credit card plan allows a grace period, the card issuer must mail your bill at least 14 days before your payment is due. This is to ensure that you have enough time to make your payment by the due date. The catch is that if you carry an outstanding balance from one month to the next, you lose your grace period. In this case, most cards charge interest immediately on all new purchases that you make.
  • Transaction fees and other charges. Credit card issuers charge other fees, too. For example, some card issuers charge a fee when you use the card to obtain a cash advance, when you are late making your payment, or when you go over your credit limit. Others charge a flat monthly fee whether or not you use the card. If you end up paying these fees regularly, you can wipe out any savings you gained from a card with no annual fee, or a low interest rate.

How is the Finance Charge Figured?

If you usually have an outstanding balance on your card, it is important to understand how your finance charge is computed. The method used can make a difference in how much interest you pay. The three main ways card issuers figure finance charges are:

  • Average Daily Balance. The average daily balance method gives you credit for your payment from the day the card issuer receives it. To figure the balance due, the card issuer totals the beginning balance for each day in the billing period and deducts any payments credited to your account that day. New purchases may or may not be added to the balance, depending on the plan. Cash advances are typically added to your balance right away. The resulting daily balances are added up for the billing cycle, and then divided by the number of days in the billing period to arrive at the "average daily balance." This is the most commonly used method.
  • djusted Balance. This balance is computed by subtracting the payments you made during a billing period from the balance you owed at the end of the previous billing period. New purchases that you made during the billing period are not included. Under this method, you have until the end of the billing cycle to pay part of your balance and you avoid the interest charges on that portion. This is the most advantageous balance method for credit users.
  • Previous Balance. This method simply looks at the balance you owed at the end of the previous billing period. Payments or new purchases that you made during the current billing period are not taken into account.

Remember that you usually forfeit your grace period if you have an outstanding balance from one month to the next. For example, let's say your balance is $500 this month. You are low on funds, so you just pay $200. This means you carry a $300 balance over to next month. By doing this you really lose twice. You will pay interest on the outstanding balance of $300, and you will pay interest on all new purchases. And you will pay interest every month until your balance is back to zero.

If you have an outstanding balance on a card that is charging you a high rate of interest, switch to a card with a lower interest rate and transfer your unpaid balances. First, ask your credit card issuer for a lower interest rate. Let the issuer know you plan to cancel your card if you can't get a lower rate. Many issuers want to keep their current customers, so will offer you a lower rate automatically for contacting them. If your lender won't cooperate with you, look for a better deal someplace else. Just be sure to read the fine print. For example, stipulations may limit the low interest rate to six months, or may not apply at all to transferred balances.

Avoid using your credit card for cash advances. A cash advance is really a loan, and usually has a hefty interest charge attached. The rate may even be higher than the interest you pay on purchases. In addition, you usually don't get a grace period with cash advances, so interest starts accruing right away.

Credit Insurance

Some creditors require or encourage you to buy credit insurance when you are purchasing an item on credit. Basically, if you die, or for some other reason are unable to continue making your credit payments, the insurance company will pay off the loan or credit card debt. This type of insurance is often overpriced and consumers rarely get value for their money. It is estimated that more than 70 percent of the purchase price goes to commissions for salespeople.

Can Interest Rates Jump?

Yes, creditors can change the interest rate on variable-rate cards without informing you. You may be surprised to open your next statement and learn that the "low-introductory" rate has jumped to a higher rate. Be vigilant. Watch for interest rate hikes. If you have a card with a high interest rate, restrict new purchases, make it a priority to pay down the debt on that card, and consider moving your unpaid balance to another card with a lower interest rate.

If you have an outstanding balance on your credit card, send in your payment as soon as you get your bill. Most issuers use the "average daily balance" method to calculate interest charges. That means additional interest charges accumulate every day your balance goes unpaid. Even if you aren't paying off the balance in full, you will pay less interest for the month _ and over the

When is Simple Interest Not So Simple?

When the lender quotes you a simple interest rate of 6 percent on a $500 loan borrowed for 1 year, the interest rate is calculated using the simple interest rate formula:

I = PRT (where I = interest)

P = principal

R = rate of interest

T = time of loan in years

In this example, the interest is $30: I = $500 x .06 x 1 = $30.

Looks easy, right? But, in reality, using credit is a bit more complicated. In most cases you do not get to use the full $500 for the entire year. Therefore, assume the loan will be paid off in 12 equal monthly installment payments beginning in 30 days. You have full use of the entire $500 for only the first month. Since the loan is completely paid off at the end of the year you will owe an average balance for the year of approximately $250. A $30 interest charge on an average outstanding balance of $250 is, in reality, costing 12 percent a year. In this case, the effective cost of borrowing (or the APR) is twice as large as the stated interest rate.

Beware the Minimum Payment Trap

The longer you take to pay off your credit card balance, the more your credit purchases will cost you. If you make only the minimum payments due every month, you may feel as though you're standing in place, or even losing ground. Your balance won't go down much, even if you're not adding any new charges. This is because when you pay just a little toward your credit card debt, most of the payment you make goes toward interest.

Monthly minimum payments have been dropping, so now most card issuers only ask for 2-3% of the outstanding balance. This helps consumers who are in a pinch _ for a month or two you can make a very small payment and still be a customer in good standing. However, if you make it a habit to only pay the minimum due, interest piles on and you will pay a lot more over time.

DO THE MATH: Credit card companies express interest rates as a monthly charge. Monthly rates are often quoted as 1 percent or 11/2 percent. This seems inexpensive, but remember, this is interest only for one month. To find the
APR multiply this number by 12. Interest at 11/2 percent per month would be 18 percent per year.

DO THE MATH: Let's say you have a balance of $1,000 on your credit card, and you do not add any new charges. If you pay only 3% each month, it will take you 10 years to pay off the balance. And you will pay almost $800 in finance charges. If your minimum payment is only 2 percent of the outstanding balance, you will be paying off this debt for almost 20 years, and will pay interest charges of $1,931.

Get Interested in Interest

A practice called "compounding of interest" can result in higher than expected interest costs. When you have an outstanding balance, the interest you are charged is added to the total amount that you owe the creditor. Last month's interest is included in the balance this month and used to calculate the interest you must pay. This increases the actual rate that you pay.

The difference in interest rates can significantly affect the money you spend on credit in a year, too. For example, let's say you have an outstanding balance of $1,000 on your credit card. The difference between a credit card with an 8 percent interest rate and a card with a 20 percent interest rate is huge. In one year, with compounding 8 percent interest, you would pay about $83 in finance charges. In one year, with compounding 20 percent interest, you would pay about $220 in finance charges. Experts say you can afford to spend about 10-20 percent of your net income on debts. This means if you take home $2,000 per month, you can probably afford to spend between $200 and $400 per month paying off debt.

Money Saving Tips

Credit is a tool and when it is used wisely it can really benefit you. To save yourself money, follow these tips:

  • Whenever possible, pay your full balance each month. This way you avoid paying finance charges. When you carry a balance forward from month to month, you lose the grace period and all new charges accrue interest right away. Remember that leaving even a small balance can result in large interest payments the next month.
  • If you usually pay your balance in full each month, get a card with no annual fee. The interest rate the issuer charges will matter less because you won't usually pay it.
  • Mail your payment as soon as you can to reduce the interest you owe and to make sure you won't pay a late fee.
  • Ask the card issuer if you can get a lower interest rate on your existing card for being a good customer.
  • Always try to pay more than the "minimum payment" to reduce your balance faster.
  • Read the mail you get from your credit card companies to spot changes in policies.
  • Save all receipts and compare them with your credit card statement.
  • If you believe there is an error on your statement, contact your credit card company as soon as you can.
  • Know when your bill usually arrives, and contact the company if it's missing. This helps you flag possible fraud.
  • If your card is lost or stolen, call your credit card company immediately. The maximum you can be required to pay for
    unauthorized charges is $50 per card, if you notify the credit card issuers promptly.
  • Never give your credit card number to someone you don't know.
  • Keep track of the amounts you have charged to avoid a fee for exceeding your credit limit.

If you have outstanding balances on more than one card, pay off the card with the highest interest rate first. Be sure to stay in good standing by making monthly payments to each of your credit card issuers, but make your largest payment to the card with the highest interest rate. This will help you pay off your debt

If you have been committing a certain amount of money each month to pay off your credit card debt, don't stop when you get one card paid off. Earmark that same amount of money to another debt, until you are completely paid up.

Lost or Stolen Credit Cards

If your credit card is lost or stolen you will be inconvenienced, but federal law caps your financial liability. You do not have to pay for any unauthorized charges that are made after you report your card lost or stolen. If your card is used before you report it lost or stolen, the most you will pay is $50 per account, as long as you report the loss within 60 days.

"Teasers" and "add-ons" are often offered by credit card companies to entice you to try their card. These gimmicks may include warranty protection, death and disability insurance, free airline insurance, frequent flyer miles, and roadside assistance. Sometimes these extras may really benefit you. Other times you don't get as much value from the so-called benefits as you expect. Remember, the key is to shop for the best card for you.

Credit Card Protection Membership: Probably Not Worth Your Money

If you receive a mailing that promises credit card protection, watch out. The sales pitch probably offers insurance to protect you from fraudulent purchases if your credit cards are lost or stolen. Most of the promised protections are things you can do for yourself, for free.

The services these companies offer are either already provided by your credit card companies or mirror protections you have under federal law. Let's look at the fine print:

  • You are promised a free credit report. You can obtain a free copy of your report if, in the past 60 days, you have been denied credit based on information in the report. If this is the case, just contact the credit reporting agency and ask for a copy.
  • There is an $8 charge for a copy of your credit report if you have not been denied credit in the past 60 days. To obtain a copy of your credit report, contact one of the three national credit bureaus.
  • You are promised registration for all your credit cards. You can compile a list of your credit cards and their toll-free customer service phone numbers. Then, if a problem occurs, you can quickly call to report lost or stolen credit cards on your own.
  • You are promised protection against fraudulent charges. Federal law already protects you against unauthorized charges on your credit cards. The law only allows your credit card company to hold you liable for a maximum of $50 per card if you report the loss or theft of a card within 60 days. If you report the card lost or stolen before it is used fraudulently, you are not responsible for any future fraudulent charges.
  • You are promised a 24-hour toll-free hotline. Your credit card companies already have toll-free hotlines to report loss or theft. In addition, credit card companies say that consumers who lose their cards usually cancel them more quickly than "credit card protection groups." Credit card issuers who offer cards with very low interest rates receive a lot of applications. As a result, they turn down many people who want their cards. Generally people who have the best credit ratings can more easily obtain credit cards with advantageous rates.

Chapter 4: Credit Reports

The Credit Handbook

Did You Know?

Outstanding credit card debt grew from $247 billion in 1991 to $514 billion in 1997. This tremendous increase can be attributed to two key factors. First, we're using credit more often and we're more willing to carry larger balances. Second, more of us have access to credit _ growth has been particularly high among lower-income consumers.

Simply put, your credit report is a compilation of data gathered by credit reporting agencies about you. The credit reporting agencies sell this information to companies and organizations with a legitimate business need to know how you manage credit.

As you've seen earlier in this book, it's important to build a good credit history. How you handle credit today will affect your access to credit later. For example, if you have a major credit card and several store cards, and you make payments on time, and pay off your bills, your credit report will show that you have been responsible with credit. This will help you when you wish to get a new credit card, finance a car, or purchase a house. A negative credit rating can hurt your ability to get further credit. This is because most creditors rely on your credit history when deciding whether to grant you credit.

What Information is in a Credit Report?

Your credit report is based on information supplied over time by your creditors. Information in your credit report includes:

  • Identification and employment data. Your name, birthdate, address, Social Security number,
    employer, and spouse's name are routinely listed. The bureau may also provide other information, such as your employment history, home ownership, income and previous address, if the creditor requests it.
  • Payment history. Your accounts with different creditors are listed, along with your credit limits, how much of each limit you've used, and how you've repaid your debts. Related items might include collection actions against you.
  • Inquiries. Credit bureaus maintain a record of all creditors who have requested your credit report within the last six months.
  • Public records. Public information that relates to your credit-worthiness, such as bankruptcy filings or tax liens, will be listed.

Creditors use all of this information to judge whether you are likely to be a good credit risk. Remember the three Cs? That's what the creditor is assessing.

If a creditor rejects your application for credit because of information in your credit report, the creditor must notify the credit bureau that generated the report. You may ask the credit bureau for a copy of your credit report. If you request it within 60 days of being turned down, the report is free.

Look at Your Credit Report

It's a good idea to look at your own report once a year, even if you have to pay to receive it. This way you'll know what the creditors know about you. Even if you have not been denied credit, it's good to find out what is in your credit file. It is especially good to look at your report if you've never reviewed it, or if you are planning a major purchase in the near future. Checking out your credit report in advance could speed the credit-granting process.

Contact Credit Bureaus to See Your Report

Contact the three major national credit bureaus to see your credit report. Expect to pay about $8 to get a report. Remember that if you have been denied credit based on the report, your report is free.

PO Box 105851
Atlanta, GA 30348-5851

PO Box 2104
Allen, TX 75013-9595

You Can Correct Errors in Your Report

Check to make sure the information in your report is correct. If you find errors in your credit report, federal law gives you the right to correct them. If you find errors, contact the credit reporting agency. Write a letter explaining what information is incorrect, and why. Unless your dispute is frivolous, the credit reporting agency must reinvestigate your claim. The credit reporting agency must correct wrong information. It also must delete any information that cannot be verified. If you disagree with the results of the reinvestigation, you may write a brief statement explaining your side of the story. At your request, your note will be included with future credit reports.

If negative information in your report is accurate, only time will erase it. Credit bureaus may report negative information for seven years, and bankruptcies for 10.

You have the right to dispute a bill with a creditor. If you dispute a bill, the creditor may not threaten to damage your credit rating or report you delinquent during the dispute. The creditor may report that you are disputing the bill.

Next Page: When Credit Goes Bad