How do credit card companies turn a profit? They achieve this through two primary means: first, they levy fees on retailers, restaurants, eateries, and other trading enterprises anytime you swipe your card to make a purchase. Second, they pull in revenue from the interest and charges they levy on you, the user. Let's delve into the workings of credit card interest and how you can manage it.
Interest is essentially the 'rental cost' associated with borrowing money, which credit card companies charge on their given loans. It is traditionally represented as an annual percentage rate (APR). Most credit cards present variable APRs, tied to a fluctuating benchmark, often the prime rate.
If the prime rate stands at 4%, and your card charges an additional 12%, your APR mounts to 16%. As it stood in June 2023, the mean APR accumulated over the credit cards documented in Investopedia's archive was 23.74%.
Typically, you only draw interest charges if you don’t pay your bill in full each month. When this occurs, the credit card company levies interest on your outstanding balance and incorporates this fee to your balance.
Additionally, some credit cards levy multiple interest rates. For instance, one rate could apply for purchases, while a different (usually higher) one applies to cash advances. Each day, if a balance exists on your card, the card company multiplies it by the daily interest rate to calculate what you owe. This rate is essentially your annual interest rate (the APR) divided by 365.
A compelling reason to shop around for a new card is the wide-ranging credit card interest rates. Your credit score typically influences the rate you're eligible to receive, with credit card companies deeming you as less risk-laden if you have a higher score.
When shopping for a credit card, comprehending your credit score and its range can aid in determining the cards and corresponding interest rates you might qualify for.
Consider John and Jane who have outstanding credit card debt of $2,000 each. Jane pays $10 more than the minimum per month, while John sticks to only the minimum. Their cards incur interest at an APR of 20% on the unpaid balances.
If John continues with his minimal payments, he’ll take 15 years to offset his card debt of $2,000, ultimately costing $4,241, with interest charges of $2,241. With Jane’s additional $10 each month, she will take seven and a half years to cover her $2,000 debt, incurring interest charges totaling $1,276. Jane’s additional $10 monthly payment helps save nearly $1,000 compared to John, additionally slashing her repayment period by over seven years.
Paying off a credit card balance could be likened to securing a guaranteed rate of return on your investment. Let’s consider your credit card levies an interest of 20% per annum. Paying off your card balance guarantees savings of 20%, tantamount to a 20% return in investment terms. When spare cash is available, it is highly advisable to use it to mitigate your credit card debt rather than invest it.
Interestingly, if you qualify, relocating your present credit card balances to a balance transfer card with a lower rate is a strategic move. Such cards typically offer promotional periods of six to 18 months where interest charges are zero, which could help you offset your balance faster. However, beware of balance transfer fees running at 3% to 5% of your existing balance.
As per Investopedia's study, as of June 2023, credit card interest charges diversely depended on the card company, the card, and the individual, with an average rate of 23.74%. The only measure against credit card interest is paying your card balance in full every month.
Credit card interest is a 'debt trap' due to the high rates levied on unpaid balances. Carrying a credit card balance over from one month to another can lead to escalating costs, contributing to the colossal household debt problem in the United States.
Smart financial practice involves paying off your credit card bill every month to evade high interest charges. If you foresee an inability to pay off your monthly bill, setting a budget and spending within your means is crucial, to avoid piling debt.