Understanding credit cards: Their purpose, positives, and potential pitfalls

Credit cards. They’re the go-to choice for millions of consumer purchases, but we also have a love/hate relationship with them. Credit cards can be a tool that helps you stay on top of your money, but they also come with a downside—particularly high interest rate charges if you carry a balance.

What is a credit card?

Basically, a credit card is a short-term loan. The credit card issuer is letting you borrow money, up to a certain limit. If you don’t pay back the full amount within a set period of time, the issuer will charge interest on the remaining balance.

Credit cards represent what’s known as revolving credit. The issuer tells you the maximum amount you can borrow. For example:

• Suppose you have a credit card with a limit of $2,000.
• You make a purchase of $800, reducing your available credit line to $1,200.
• Next, you make a payment of $400. Now your available credit is back up to $1,600.
• Your balance is $400 at the end of the billing cycle, and an interest charge of $9.33 is added to your account.
• Starting with the next billing cycle, your available credit is $1,590.67.

As you pay down your credit card balance, you “free up” more room to spend. But how does it all work? And how did they come up with that interest charge?

Here’s a breakdown.

How to calculate credit card interest

There are a couple of ways to figure out how much interest you’re being charged on a balance. The easiest is to base it on a monthly charge. If your APR is 22.99%, your monthly interest rate is approximately 1.92%. At the end of the month, if the balance on your credit card is $800, you can multiply that amount by 0.0192 to find that you will pay about $15.33 in interest.

Many credit cards charge daily interest. This is where things can start to get interesting. First, you divide your APR by 365 to get your daily interest rate. For our example, that means 22.99 / 365 = 0.06299%.

• At the end of the day, look at your balance. Let’s say it’s $900.
• Multiply $900 by 0.0006299 to get $0.57.
• The next day, your balance (if you haven’t spent any more) is $900.57.
• Now, you can multiply $900.57 by 0.0006299 to get another $0.57.
• Your new balance on the following day is $901.14. Let’s say you spend $50 filling up the gas tank.
• Your new balance is $951.14. Your new daily interest charge is $0.60.

Here’s the good news: If you pay off your balance before the end of the monthly billing cycle, none of this interest actually gets added to your balance and it isn’t charged to you. But if you don’t pay off, it all gets tacked on to what you owe.

You can see how this interest could add up over time, even though the amounts seem small on a daily basis. In our example, if you just stuck with the $900 balance and were charged $0.57 per day, at the end of a 30-day billing cycle, you’d be paying $17.10 in interest. With a higher APR and a higher carried balance, this could quickly become overwhelming.

That’s the power of compounding. On money you earn, compounding acts as a turbo-charger. But when you’re paying interest, compounding adds to the pain.

Credit card payments

To understand credit cards, you also need to understand how the payments work.

Many card issuers offer a minimum payment, which is the smallest amount that’s still considered a “full” payment. But if you only pay the minimum, it can take much longer to get rid of credit card debt. Many card issuers set the minimum payment at somewhere between 3% and 5% of your balance. If you have a high APR, your minimum payment might barely cover your interest.

Suppose your credit card balance is $1,000 with a 27.99% APR. For simplicity, we’ll base this on a monthly interest calculation. Your credit card issuer figures a minimum payment based on 3% of your balance.

• Your monthly interest is 2.33%, resulting in $1,000 x 0.0233 = $23.33 in interest.
• Your minimum payment is $1,023.33 x 0.03 = $30.70.
• If you pay the minimum, $23.33 will go to pay the interest, leaving just $7.37 to reduce the original principal of $1,000.
• Your new balance at the beginning of the next cycle is $992.63.

If you only pay the minimum payment—even if you never charge another dime—it will take you five years and seven months to pay off that original $1,000, and cost you about $986 in interest! This is why it’s so important to pay off what you spend each month—or at least pay as much as you can.