Understanding Credit Cards: Their Purpose, Benefits, and Potential Drawbacks
Credit cards. Millions of consumer purchases rely on them, but we also have a love/hate relationship with them. Although credit cards can be a useful tool for managing your finances, they do have drawbacks, including high interest rates if you carry a debt.
What you need to know about credit cards, how they operate, and how to prevent falling into a debt trap are provided below
What Exactly Is a Credit Card?
A credit card is essentially a short-term loan. You are permitted to borrow money from the credit card company up to a certain limit. The issuer will assess interest on the remaining debt if you don’t repay the entire amount within a predetermined amount of time.
Revolving credit is represented through credit cards. The maximum loan amount is disclosed by the issuer. For instance:
- Let’s say you have a credit card with a $2,000 limit.
- Your credit limit is now $1,200 after you make a $800 purchase.
- You then send over $400 as a payment. Your credit limit has now been restored to $1,600.
- At the end of the billing period, your balance is $400, and $9.33 in interest is applied to your account.
- Your available credit is $1,590.67 as of the following billing cycle.
Your available spending money increases when your credit card balance is paid down. But how does everything operate? And how did they determine the interest rate?
Here is a summary.
Interest on credit cards
Credit card interest is the first crucial idea to comprehend. Normally, credit cards run on a monthly billing cycle. There is a grace period of a few weeks before the “due date” at the conclusion of each cycle. You normally pay no interest if you settle the entire sum on the due date.
However, interest will be added if you don’t (or are unable to) pay the full debt.
Interest rates are determined by two factors:
The issuer’s annual percentage rate (APR). The percentage of your balance used for this is. You have the option of daily or monthly interest accrual. If you don’t pay off the balance on your credit card each month, many of them charge interest every day.
Your credit card balance. The issuer will assess your balance at the conclusion of each payment cycle and apply the APR.
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How to Calculate Interest on Credit Cards
There are several methods for calculating the interest rate being applied to a balance. The simplest approach is to base it on a monthly fee. Your monthly interest rate is roughly 1.92% if your APR is 22.99%. If your credit card balance is $800 at the end of the month, you can calculate your interest payment by multiplying that amount by 0.0192 to get an estimate of $15.33.
Daily interest is charged on many credit cards. Things may start to become interesting at this point. To determine your daily interest rate, divide your APR by 365. This translates to 22.99 / 365 = 0.06299% in our scenario.
- Check your balance at the end of the day. Consider it to be $900.
- To get $0.57, multiply $900 by 0.0006299.
- If you don’t make any further purchases, your balance the following day is $900.57.
- To obtain an additional $0.57, multiply $900.57 by 0.0006299.
- The following day, your new balance is $901.14. Say you spent $50 to fill up the car with gas.
- It now stands at $951.14. Your daily interest rate has increased to $0.60.
The good news is that none of this interest is really applied to your balance and is not charged to you if you pay off your amount before the end of the monthly billing cycle. However, if you don’t pay it off, it’s all added to the amount you owe.
Even if the sums appear little on a daily basis, you can see how this interest could accumulate over time. In this example, after a 30-day billing cycle, you would have to pay $17.10 in interest if you simply kept the $900 balance and were charged $0.57 every day. This might easily get out of hand with a higher APR and carryover balance.
That is how compounding works. Compounding functions as a turbo-charger for money you earn. Compounding, however, makes interest payments more painful.
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Credit Card Payments
You must comprehend how payments operate in order to comprehend credit cards.
The smallest sum that is still regarded as a “full” payment is the least amount that many card issuers accept. However, paying off credit card debt can take a lot longer if you merely make the minimal payments. The minimum payment on many credit cards is set at between 3% and 5% of the outstanding debt. Your minimum payment might not even cover your interest if your APR is high.
Let’s say you have a $1,000 credit card balance with a 27.99% APR. We’ll base this on a monthly interest calculation to keep things simple. A minimum payment is calculated by your credit card company using 3% of your debt.
- Your interest rate is 2.33% each month, therefore $1,000 times 0.0233 equals $23.33 in interest.
- $1,023.33 x 0.03 = $30.70 is your required minimum payment.
- If you only make the minimum payment, only $7.37 will be used to lower the $1,000 initial principal because $23.33 will be used to pay interest.
- Your new balance will be $992.63 at the start of the following cycle.
It will take you five years and seven months to pay off that first $1,000 if you merely make the minimum payment—even if you never charge another penny!—and it will cost you around $986 in interest. For this reason, it’s crucial to pay off all you spend each month, or at the very least, as much as you can.
Also Read: How to Benefit from Rising Interest Rates
Fees for Credit Cards
Don’t overlook credit card fees, too. Depending on the card, some fees could be as follows:
- Annual Fee
- charge for late payment
- Over-the-limit fee
- Balance transfer fee
- Cash advance fee
Your balance can be increased by all of these charges, and interest will be added to the total. Find out what possible fees are and how they affect the overall cost of borrowing before you apply for a credit card.
Credit cards can help you improve your financial situation and can even enable you to accrue perks and cash back. However, they also have a drawback. Debt can be acquired quickly, and you may end up paying a high price in the form of interest and fees.
Establish a budget and make sure you are familiar with credit cards’ workings before applying for one. Spend only what you have budgeted for, and make an effort to pay off the credit card each month to prevent interest charges.
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