The Credit Handbook
The Cost of Credit
With approximately 70 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 annual fee and the other is the interest rate (usually called the “annual percentage rate” or APR). 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.
- 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.
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.
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:
1. 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.
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 long run.
2. Adjusted 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.
3. 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.
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 are usually very low—most card issuers only ask for 2-4 percent 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: 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 the minimum payment of 3 percent 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.
Also called a “free period,” a grace period 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 send you your bill at least 21 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.
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.
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.
Do the Math: Credit card companies express interest rates as a monthly charge. Monthly rates are often quoted as 1 percent or 1½ percent. This seems inexpensive, but remember, this is interest only for one month. To find the APR multiply this number by 12. Interest at 1½ percent per month would be 18 percent per year.
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.
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.
Can Interest Rates Jump?
Yes, creditors can change the interest rate on variable-rate cards, but must provide you notice of the change. 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.
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.
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.
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.
Minnesota consumers are eligible to obtain free annual copies of their credit reports. An amendment to the federal Fair Credit Reporting Act requires each of the three national consumer reporting agencies to provide consumers with an annual copy of their credit report for free.
You can also obtain a free copy of your report if, in the past 60 days, you were denied credit based on information in the report. If this is the case, just contact the credit reporting agency and ask for a copy.
You are promised registration for all your credit cards.
You can make 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 require you to pay 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.”
Be on the Lookout
Companies have started to make aggressive, misleading, and deceptive telemarketing calls to sign people up for optional financial products, in some cases, charging people’s credit cards for enrollment even though the consumer did not agree to purchase anything. In other cases, people are tricked into unknowingly signing up for these products, usually by inducing consumers to say “OK” or “yes” to a benign statement on the phone without understanding they are signing up and then treating that response as authorization to bill their credit cards.
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.
- Make a 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 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 for another debt, until you are completely paid up.
- 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 more quickly.
- 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 they 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 immediately.
Is Credit a Trap?
Credit can work for you or against you. It depends how you use it. Let’s look at an example. We know the average American family that carries credit card debt owes $15,611. Let’s say a family has this debt on one card. The card has an annual percentage rate of 18 percent and requires a minimum payment per month of 4 percent of the outstanding balance. If the family chooses to make just the minimum payment each month, the family will be paying this debt off for 15 years! That’s a long time. The double whammy is that the family will pay a lot, too. The total the family will pay is $24,850.98. The additional $9,239.98 is the interest they will pay!