Most people know that if you don’t pay off your credit cards each month you’ll be charged interest. However, for one reason or another, so many of us allow this debt to accumulate anyways. According to research by Go Banking Rates, more than half (53 percent) of Americans carry a revolving balance on their credit cards.
Perhaps one reason for this is a misunderstanding about the way credit card interest works and the effect it may have on our finances. To set the record straight, in this post we’ll dispel three common myths about credit card interest and explain how it’s hurting you in the long run.
1) The Interest Will Build Daily
Myth: Interest charges are only added at the end of the credit cycle (when you get your bill at the end of the month).
Truth: Unfortunately when it comes to credit cards and interest, the game is stacked against you in a major way. Despite what you may have been told by others in the past, credit card interest is charged daily, not monthly.
Here’s how credit card interest actually works:
- The APR that appears in your app and on your credit card statements is the annual rate for that particular cycle. In reality, that charge is divided by 365 to create what’s called your daily interest rate.
- Starting on the first day you carry a revolving balance (i.e., you don’t pay your credit card bill off in full), this amount is multiplied by the daily interest rate, and the interest charges are added on top of your balance.
- The next day, this new balance (with the interest from yesterday) is multiplied by the daily interest rate again. Another day of interest is added to your balance, this time more because of the interest from the day before.
- This cycle continues for as long as the revolving balance remains unpaid.
Investors will recognize that process as the way compound interest works. However, in this case, it’s working negatively against you. With each day that passes, your interest bill is compounding with money growing on top of the previous balance plus any new interest charges.
This is why people who are in credit card debt often find themselves in a spiral where they can’t get out. Despite making the minimum monthly payment, the interest charges pile up fast and it results in years before the balance is ever paid off.
The only solution to this problem is not to get into debt in the first place. Always pay your balance off in full each month and never let any of it carry over. If you can’t afford to pay off your credit card balance in full each month, then you need to reevaluate your spending habits by making a budget and learning to live within your means. A helpful budging app such as Buxfer can be a very efficient way to do this.
2) Interest Rates Can Change
Myth: The interest rate you got when you applied for your credit card is the rate you will always have.
Truth: Most conventional credit cards come with what’s known as a variable interest rate. This means that the credit card company is free to alter this rate any time they wish for any reason (with appropriate notification to the cardholder).
For example, you may have been quoted an interest rate of 16.9% when you first signed up for your credit card. However, that may or may not be the case any longer for a variety of reasons:
- If you’ve ever missed a payment or failed to meet the minimum requirement, then the credit card company may have increased your rate seeing you as a potential risk.
- If your credit score (also called your FICO Score) has gone down due to other financial difficulties, then the credit card companies will eventually find out. Again, a lower score means you’re no longer seen as being creditworthy, and so they will increase your rate.
- When the Federal Reserve decides it’s going to raise the federal lending rate, this has a ripple effect throughout the entire industry. The rates on all financial products from mortgages to auto loans and even credit cards will also increase. This even happens to people with Excellent credit scores to no fault of their own.
Again, the only real way to protect yourself is to put yourself in a position where interest won’t be charged, and that’s done by not carrying a balance. People who pay their cards off every month can go years without having any idea what their lender’s APR is, and that’s okay because it never affects them.
3) Being Charged Interest Does Not Help Your Credit Score
Myth: Paying your credit card balances off a little bit at a time and allowing interest to be charged will make you look good in the eyes of creditors.
Truth: Interest never helps to boost your FICO Score. Purposely only paying the minimum amount instead of the full balance each month will not make you appear more desirable to creditors or improve your score. While credit card companies make money off of the interest they charge clients, they actually prefer that their customers consistently and reliably pay them back on time.
In terms of your credit score, letting interest accumulate actually hurts you over time due to a known factor called your “credit utilization ratio”. This is the amount of your balance divided by your total available credit. For example, if you charged $2,500 and had a credit limit of $10,000, then your credit utilization ratio would be 25 percent. Most experts agree that this figure should stay below 30 percent or it will start to have a negative impact on your FICO Score.
When you carry a balance or let interest accrue, it can quickly escalate your credit utilization ratio. For example, suppose you only paid off $500 of that $2,500 balance from last month and let the remaining $2,000 revolve into the next credit cycle. You might be charged around $25 in interest plus make another $2,500 in charges for the following month. At that point, your credit utilization ratio has now ballooned to:
($2,000 + $25 + $2,500) / $10,000 = $4,525 / $10,000 = 45.25%
Since you would have now crossed over the 30 percent threshold, you’d most likely begin to see a negative impact on your credit score.
When it comes to your credit, stick to the facts. FICO has published very clearly on its website what factors they consider when calculating your credit score. Basically, if you use a common sense approach of paying off your bills on time every month and not using too much of your available credit, then your score will likely be just fine.
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