Hi all.
A credit card is a loan. You are borrowing money from a credit card company. Loans aren’t free money!
Let’s create an imaginary credit card, at 20 percent annual interest and buy a 200 dollar item with it. There will be a 30 day billing cycle.
The balance is $200. You owe $200. You have to repay this, plus a finance charge.
What is the finance charge on the balance? Finance charge = Average daily balance * APR * Number of days in billing cycle / 365 days in a year
What is the average daily balance? Average daily balance = (Balance on day 1 + … + Balance on day N) / Number of days in billing cycle
Assuming that we don’t repay this loan at all during the month, the finance charge is:
Average daily balance = $200 * 30 days not repaid / 30 = $200
Finance charge = $200 * 0.20 * 30 / 365 = $3.29
So you must repay $200 plus $3.29. Sound small?
Well, let’s pretend that you do not repay the loan at all for 43 months (3 years and 7 months). The accumulating finance charge will be close to $141.47 ($3.29 x 43 months).
The minimum payment
There is a certain percentage that credit cards require in payment, which is pretty small. Let’s calculate it for our imaginary $200 debt:
200*x = 3.29
x = 3.29/200
x = 0.01645
The minimum payment on this balance is 2 percent.
If we paid 2 percent on $203.29, the balance would go down by $4.07, but it would be offset by $3.34 of finance charges. So the balance next month would be: $202.56. So effectively it has gone down by 73 cents! Some credit cards have an exact minimum payment also attached, looking like: The greater of 3% of the balance or 30 dollars. Even if 30 dollars is greater than 3 percent of the balance, the 30 dollars is eaten up by finance charges in about a year, assuming that the loan is not repaid by then.
Paying it off “early”
Maybe you’ve never realized that you can pay off your credit card loan earlier in the month. This results in a lower finance charge. Huh? Let’s try it out.
Using our imaginary $200 loan, let’s pretend we make a $50 payment every 5 days, stopping the third week.
Visualization:
Day 1 to 4 – $200
Day 5 to day 9 – $150
Day 10 to day 14 – $100
Day 15 to day 30 – $100
Let’s determine the finance charge:
Average daily balance = ($200 * 4 days) + ($150 * 4 days) + ($100 * 15 days) / 30 days = $800 + $600 + $1500 / 30 days = $2900 / 30 = $96.67
Finance charge = $96.67 * 0.20 * 30 / 365 = $1.59
We have saved $1.70 by paying $50 every 5 days. This can add up to a lot of money over many years.
The lesson here? Credit cards are not a very good way to go if you cannot repay the loan at the end of the month, and/or every few days.
