Most of us have probably heard someone say “credit cards are evil”. We’ve heard people say credit card interest is dangerous. We’ve heard not paying off your credit card in full is a surefire way to spend added thousands for the privilege of spending money we don’t have. I hear stories of people in crazy amounts of credit card debt with balances I didn’t know were possible on a credit card. But how does credit card interest work? How much does it truly cost other than “a lot”?
As someone who pays my card in full every month, I really had very little idea the mechanics behind how credit card companies calculate credit card interest. I just assumed credit card interest continually compounded forever and ever. But does that mean then that you’re doomed to never actually pay off the full balance? I failed to consider how the minimum payment even helps to pay off the card. I had questions like:
- When do you get charged interest for your credit card?
- How do credit card companies determine how much interest you owe?
- When must credit card interest be paid?
- How is the minimum payment calculated at the end of the month?
- Will paying only the minimum payment really eventually pay off your credit card?
- How does the credit card grace period factor into all this?
Well, little did I know that all this information was actually sitting right there in my credit card member agreement! But who has time to read those? Especially when they’re filled with jargon.
How many of us have really glossed over them after getting a credit card? I don’t even bother to check the APR since I’ve committed to paying off my balance. But still, aren’t these things we should know?!
I’m going to be taking a look into my Chase Freedom Credit Card Agreement. If you’re curious about the details of a specific credit card, you can probably find a copy of it on your credit card company’s website.
Before I get into specific and detailed examples of dollar amounts you may find yourself paying, let’s answer the questions I listed above first.
Avoiding Interest Is Easy!
Pay your statement balance by the due date shown on the statement. You will not be charged interest.
If you pay anything less than the statement balance, you will be charged interest. Examples of paying less than the statement balance:
- $1 less than the statement balance
- Minimum payment
- Missing a payment
There’s a huge myth that if you make the minimum payment on your statement, you will not be charged interest. Generally, if someone is borrowing money and someone is lending money, interest is charged on the amount that the borrower hasn’t paid back. Similarly, credit card companies charge interest on any borrowed money that hasn’t been paid back by the due date. If you’re only making the minimum payment, you’re obviously not paying back all the money you borrowed. That leftover borrowed amount that hasn’t been paid back will be charged interest!
The only thing paying the minimum payment does is keep your account in good standing so that your credit score will not be negatively impacted. You will be charged interest if you only pay the minimum. Paying the minimum payment at each due date communicates your intention to eventually pay back what you borrowed. That’s it.
Let’s think about things in terms of a loan. When you take out a loan, like a mortgage, you usually have a timeline for paying it back. Let’s take a 15 year mortgage for example. You have 15 years to pay back that loan, but how can the loan company guarantee you’ll pay them back? Surely they can’t trust you to be saving to pay them back the lump sum + interest you owe them at the end of the 15 years right? They guarantee you’ll pay them back on time by giving you a minimum payment, which includes paying off some of your principal and paying some interest. If you continue making the minimum payment, you’ll be able to completely pay back the amount you borrowed + interest in 15 years.
Unlike a loan, credit cards have no date or time they expect you to pay back the money you borrow. Making the minimum payment is a signal that you plan to eventually pay back the borrowed amount, but in the mean time, credit cards will be greedily collecting interest on the amount you borrowed and haven’t paid back yet!
This is why almost all credit card articles will tell you to pay your statement balance in full! To make things easier, I’ve broken down the consequences of different credit card payment scenarios:
|Pay Full Balance||Min Payment||Late Payment||Missed Payment|
|Negative Credit Score Impact||x||x|
|Interest Rate Increased||x|
Calculating Credit Card Interest
First off, you don’t owe any interest on your balance if you pay the full balance by the due date. If you don’t pay the balance by the due date, then every purchase you make will begin to accrue interest.
“We will not charge you interest on purchases if you pay your entire balance by the due date each month.”
With every credit card agreement comes an APR. Mine is 18.99% on this card. It’s an interest rate that represents the percentage of interest you can expect to pay in a year.
That doesn’t mean you get charged at the end of the year though. Most credit cards will charge interest daily. On page 11 of my Chase Freedom agreement is this giant wall of text:
Basically it’s saying that they break down interest to a daily rate. So:
Daily Interest Rate: 18.99/365 = 0.052% per day
Then they calculate my daily balance at the end of the day, including all new spending and payments for the day. For example:
Current Unpaid Balance At Start of Day: $200
Buy lunch + dinner during the day: $50
Make a Payment to My Credit Card: $10
Current Unpaid Balance At End of Day = Daily Balance = $200 + $50 – $10 = $240
Then they use the daily balance and daily interest rate to determine how much to charge you in interest for that particular day:
Daily Balance x Daily Interest Rate = $240 x 0.00052 (or 0.052%) = $0.12 of interest
Then they will add that interest charge to the unpaid balance on your card and use it to calculate the interest to be charged for the next day. This is called compound interest:
Current Unpaid Balance: $240.12
The interest will continue to compound until the next due date on your card.
I’d also like to point out that some cards have a Minimum Interest Charge.
This means if you do have an unpaid balance that can have interest charged on it, but at the end of the month the 30 days of interest are less than the Minimum Interest Charge, the credit card company can automatically charge you the Minimum Interest Charge. That means you’re actually paying more interest than what you technically owe based on how much money you’ve borrowed on the card. The Chase Freedom lists its Minimum Interest Charge as $0.
The reason the agreement keeps mentioning daily balance for each transaction type is due to the fact that you can do more than just make purchases with your card. You can also take out cash advances and make balance transfers, which have their own APR. So each of these buckets have a daily rate calculated separately from each other.
Credit Card Interest Due Date
While the credit card agreement doesn’t specifically say when interest + fees are due, if we read the fine print for determining the minimum payment, we can see that the monthly minimum payment actually includes interest + fees.
The minimum payment is either $25 or 1% of the unpaid balance + total interest charges + fees. The total interest charges are the daily interest charges added up for the month.
Similar to other types of lenders, credit card companies take your minimum payment and first apply it to the interest and fees you owe them. Then they apply the rest to your credit card balance, also known as the principal. For many, this means the majority of your minimum payment is in reality going towards interest + fees, not the principal. That means you begin the next month’s cycle with a high balance ready to accrue almost the exact same amount of compounding interest.
Calculating Your Minimum Payment
While hunting down the answer to the previous question, I inadvertently answered this question already! The minimum payment is whichever is more:
$25 = Unpaid credit card balances that are less than $2500 (1% of $2500 = $25)
1% of the credit card balance + accrued interest + fees
Paying The Minimum Payment Works…After A Really Long Time
While researching minimum payments, I actually discovered that credit card issuers are legally obligated to tell you the consequences of paying only the minimum payment! You can find this information on your monthly statement. I usually get my monthly statements online, above is a screenshot from my latest statement.
The amount of interest I’d pay is a depressing reality! It’d take me 7 years to pay off IF I didn’t spend any more money on the card. I’d pay almost double what it actually cost and $800 ($2007-$1207) would be interest!
To put this in perspective, if I took out a personal loan with an interest rate of 6% and a minimum payment of $25, I’d only pay $179.85 in interest. (Below is a screenshot from the Bankrate personal loan calculator)
Credit Grace Periods Are Magic, Until They’re Not
Because I’m someone who pays off their credit card in full every month, the only thing I was familiar with when it came to credit card interest was the grace period, otherwise known as the interest free period. Basically this allows you to spend money on your card, and as long as you pay the full balance by the due date, you’re never charged any interest.
So if I spend $200 from September 2 – October 1, I won’t be charged interest until October 26.
“Your account is in an interest-free period when you pay your New Balance as shown on your statement every month by the due date and time.”
The interest free period is only available if you pay your New Balance every month by the due date. This is a fancy way of saying you must pay off the entire card’s balance by the due date on your statement to continue having this interest free period.
While I was researching, I found myself completely confused by what “New Balance” meant. At first I thought it meant the new purchases I made in the current billing cycle. So if I carried over $200 from last month’s balance, and I spent $100 this month and paid $100 + interest on last month’s balance off my card, I should technically not be charged interest on the new purchases because I paid the new balance right?
Well, in retrospect, this logic didn’t make much sense. It doesn’t make sense because when you’re carrying a balance from a previous statement (the $200), your credit card payment will be applied first to the oldest spending, not the newest! So if you don’t pay enough to cover both the previous balance and your new purchases, you’ll of course be charged interest as well on the new purchases. This is totally obvious if you just stop to think about it.
After looking at my statement, I saw that the New Balance for Chase uses this calculation:
New Balance From The Last Billing Cycle – Payments + New Spending + Interest + Fees
If you’re paying the minimum payment, you aren’t ever in an interest free period. If I’m only making the minimum payment, there’s no way I could be paying the New Balance by the due date. Which means even purchases you put on your card that same day will have interest calculated:
“We charge interest on purchases from the date the transactions appear on your account (until the balance is paid in full) when your account is not in an interest-free period.”
Show Me An Example Already!!
Let’s say I have a $10,000 unpaid balance from my previous statements, and this month I won’t be spending any additional money on the card. Let’s take a look into how the credit card is calculating the interest I’ll owe at the end of this current statement.
Let’s say my APR is 18.99%, so my daily interest rate is 0.052%.
|Billing Cycle||Total||Interest Calculation||Interest Charged|
|Day 1||$10,000.00||10,000.00 x 0.00052||$5.20|
|Day 2||$10,005.20||10,005.20 x 0.00052||$5.21|
|Day 3||$10,010.40||10,010.40 x 0.00052||$5.21|
|Day 4||$10,015.62||10,015.62 x 0.00052||$5.21|
|Day 5||$10,020.83||10,020.83 x 0.00052||$5.21|
|Day 6||$10,026.04||10,026.04 x 0.00052||$5.22|
|Day 7||$10,031.26||10,031.26 x 0.00052||$5.22|
After only 7 days, I already owe $36.48! And every day the balance I owe is larger and larger, even though I actually only spent $10,000 originally. Let’s see how the rest of the month plays out:
The end of the month leaves us at $10,157.27 + $5.28 of interest as our New Balance. The last interest charge needs to be added to the last day’s total because it is calculated at the end of the day. That leaves us paying $162.55 of interest. Now let’s calculate the minimum payment Chase would make us pay towards our New Balance of $10,162.55.
1% of the balance (without interest) = $10,000 x 0.01 = $100
Interest = $162.55
Fees = $0
Minimum Payment = $100 + $162.55 = $262.55
If I were to only pay the minimum balance, then I would only knock off $100 from my principal of $10,000. Meaning at the beginning of the next billing period, I’m being charged interest immediately on $9,900…the interest is almost exactly the same!
|Billing Cycle||Total||Interest Calculation||Interest Charged|
|Day 1||$9,900.00||9,900.00 x 0.00052||$5.15|
|Day 2||$9,905.15||9,905.15 x 0.00052||$5.15|
|Day 3||$9,910.30||9,910.30 x 0.00052||$5.16|
|Day 4||$9,915.46||9,915.46 x 0.00052||$5.16|
|Day 5||$9,920.62||9,920.62 x 0.00052||$5.16|
|Day 6||$9,925.78||9,925.78 x 0.00052||$5.16|
|Day 7||$9,930.94||19,930.94 x 0.00052||$5.17|
At the end of this next billing period, I owe $160.92 in interest. My minimum payment comes out to:
1% of the balance (without interest) = $9,900 x 0.01 = $99
Interest = $160.92
Fees = $0
Minimum Payment = $99 + $160.92 = $259.92
At the end of this billing cycle, I’ve knocked $99 off my principal of $9,900. The next billing cycle will start charging interest on $9,801.
Writing out these monthly calculations make me dizzy with how hopeless paying the minimum is! If I plug this balance into a calculator, it tells me it would take me 28 years and 7 months to pay off the original $10,000, in addition to paying $15,239.60 in interest.
This projection is based on no additional spending on the card. You could seriously end up in debt for the rest of your life if decide you want to keep spending on your card.
If you want to plug in your numbers yourself, I really like Bankrate’s Minimum Payment Calculator which tells you the true cost of paying only the minimum.
There’s a reason why credit card companies are legally required to warn you about the consequences of paying only the minimum payment. Would you still borrow that $10,000 if someone told you up front you had to pay $15,000 to borrow that money?
Let’s look at the breakdown according to Bankrate’s Minimum Payment Calculator for different debt levels at 18.99% APR and Chase’s minimum payment rules:
|Debt||Min Payment||Total Interest||Pay Off Time|
|$500||$25||$106||2 Years, 1 Month|
|$1,000||$25.83||$989.65||9 Years, 7 Months|
|$5,000||$129.17||$7,322.79||22 Years, 11 Months|
|$10,000||$258.33||$15,239.60||28 Years, 8 Months|
|$20,000||$516.67||$31,072.75||34 Years, 5 Months|
|$100,000||$2,583.33||$157,744.42||47 Years, 9 Months|
In reality, you may pay more or less in interest because the debt may be spread out on different cards with different minimum payment rules. Different cards may also have different APRs. But you get the point, it costs exponentially more to borrow more on your credit card if you don’t plan to on paying it off quickly.
When it comes to debt, knowledge of the mechanics of the debt you’re carrying is the first step in understanding why you need to tackle it. When I was searching for articles on how credit card debt works, I really had trouble finding out how it worked, every article just threw out confusing numbers assuming I knew this or that calculation. I hope this gave some of the background knowledge you’ve been confused about too!
Did you learn something new about credit cards that you didn’t know before? Are there any other examples you’d love to see?