In 2019, total consumer debt in the United States hit $4 trillion for the first time in history. Unfortunately, a big portion of this is credit card debt. In fact, the average person has around $4,293 in credit card debt.
If the balance on credit cards is high, you may feel like you’re treading water and never making any real progress toward getting your debt under control.
Are credit cards free? No they are not, the lack of a fundamental understanding of how credit cards- and the interest charges that go along with them has serious consequences. It is important to understand how to pay back credit cards.
How do credit cards work technically?
You may think you know how credit cards technically work, but do you truly understand how interest is calculated?
When you make a purchase with your credit card, you essentially take out a short-term loan from the credit card company. This “loan” becomes your balance, which is what you owe at any given time.
Each time you make a payment, you’re paying on this loan. Like any other loan, credit cards charge you interest for the privilege of “borrowing” money.
How can you avoid credit card interest?
You can think of a credit card as a loan, but did you know there’s a way to avoid paying any interest on your credit card? If you pay off your entire balance before the payment due date, you won’t pay a single penny in interest.
How? By taking advantage of the grace period. This is the short time gap between the close of your card’s billing cycle and the next payment due date. Grace periods vary by lender, but they generally run somewhere between 21 and 25 days.
This means there is roughly a 21-day gap between the end of your billing cycle and the date your payment is due. Essentially, this is a 21-day (or more) interest-free loan. There is no such thing as credit card grace period after due date.
So why doesn’t everyone take advantage of this short-term, interest-free loan? The reality is that most people don’t pay off their credit card bill every month. Instead, they carry a balance. Once you do this, you’ll get charged interest on the purchases you make.
However, purchases aren’t the only things that end up on your credit card bill. In addition to the amount charged for the item, you can rack up other common credit card fees like interest, annual fees, and late charges.
If you pay your balance in full and on time every single month, you won’t accumulate these extra costs. If you may the minimum monthly payment, however, the additional costs can quickly cause your balance to balloon out of control — especially if you continue adding new purchases.
What is credit card compound interest?
The easiest way to define credit card compound interest is “interest on interest.” This is the interest you pay on your principal (the original amount you owe) plus any previous interest that has been rolled into the debt.
If you imagine a snowball rolling downhill, picking up more and more snow and debris as it travels, that’s a good visual depiction of compound interest. As your balance gets bigger, you get charged more in interest each month.
Compound interest isn’t necessarily a bad thing. For example, it can work in your favor if you earn interest on a savings account.
Let’s say, for instance, that you have $100 in a savings account that earns 5 percent interest each year. When the year ends, you’ll have $105, which is obviously more than you started with. Use this calculator from The U.S Securities exchanges to calculate compound interest.
The following year, you’ll earn interest on your original $100 plus the $5 you earned in interest — essentially earning interest on your interest. This is compound interest.
Statement Balance vs. Current Balance: Know the Difference
It’s important to distinguish between the statement balance and the current balance on your credit card bill. When you get your statement in the mail (or check your account online), you generally have four options for making a payment.
Specifically, you can pay the statement balance, the current balance, the minimum monthly amount due, or some other amount of your choosing. Let’s look at all four.
Statement Balance
This is the amount you owe at the end of any particular billing cycle. It’s a frozen, moment-in-time look at your account, which includes the total of all the purchases, interest, fees, and prior balances that have added up or carried over from last month’s statement. You can also think of it as a snapshot.
If you pay this balance off completely before the due date, you won’t have to pay any interest. Keep in mind that your statement balance will remain unchanged until you get your next statement in the next billing cycle.
This means you can continue to accumulate charges that exceed the amount listed on your most current statement balance.
Current balance on credit card
Instead of a snapshot taken in a moment in time, your current balance is the real-time balance on your credit card. Your current balance updates and changes every single time you make a purchase or charge something to your card.
If you pay your current balance, keep in mind that any pending charges or fees that have yet to post may still show up on your next statement balance.
Minimum Payment
This is the payment you need to make to maintain your account in good standing with no late payments. While you’ll avoid late fees by paying this amount, you will still accumulate interest and compound interest over time.
This is why sticking with the minimum monthly payment is a bad strategy. If your credit card balance stays the same even though you make monthly payments, you’re probably making the minimum payment while continuing to rack up interest.
Other Payment of Your Choosing
You can also choose to pay more than the minimum payment. Doing so will save you interest. If you can’t afford to totally pay off your credit card each month, you should at least aim to pay more than the minimum payment.
What is your credit utilization rate?
In some cases, a person pays their credit card bill on time every month, making the minimum payments, yet their credit score is still low.
This is usually because their the balance on credit cards balance is too high. When your balance is high, you use up most of your available credit. This can hurt your “credit utilization.”
Your credit utilization is how much credit you have available compared to how much you’re using. Because it makes up 30 percent of your credit score, a high credit utilization can really hurt your score.
Together, there are five factors that make up your FICO® credit score, and some carry more weight than others. They are:
- Payment history (35% of your score) – This is whether you pay your bills on time.
- Credit utilization (30% of your score) – How much available credit you have versus how much you use.
- Credit history (15% of your score) – How long you’ve been using credit.
- New credit (10% of your score) – How many new accounts you have on your credit report.
- Mix of credit (10% of your score) – Your variety of different credit types.
You can calculate your credit utilization by dividing your balance by your credit limit, then multiplying that number by 100.
For example, if you have a credit card with a $5000 limit and you carry a balance of $3000, your credit utilization is 60 percent.
Generally, you should aim to keep your credit utilization rate below 30 percent, which means your current credit utilization is much too high.
A high credit utilization can also mean getting saddled with higher interest rates, since you pose more of a risk to creditors.
If you’re using up most of your available credit, you don’t have any remaining credit to fall back on if you need it. This can make creditors wary of doing business with you.
You can check your credit score for free by signing up for the Discover Scorecard. There are no strings attached, and you don’t have to open a Discover card to get access to your score.
Is it good to leave a balance on credit card?
If possible, you should do your best to avoid carrying a credit card balance. Instead, try to pay it in full every single month. This lets you avoid interest charges that can snowball from month to month.
Does using a credit card build credit?
You may have heard that having a credit card can help your credit score. While this is accurate, carrying a balance does nothing to help your score — and may even hurt it if you make a late payment or use so much credit that your credit utilization exceeds 30 percent.
To protect your finances and keep your credit score as high as possible, you should avoid credit cards if you struggle to use them responsibly.
By paying the balance on credit cards in full each month, you avoid accumulating interest and other fees. This puts you in total control of your money and helps you avoid giving any extra dollars to the credit card company.
