Most of the ads I see on Facebook are ones encouraging me to apply for more credit cards. Using the power of the “internet cookie,” Facebook knows that I’m a credit card fiend, and I crave the latest and greatest card with the best rewards program. You see, at the ripe old age of 22, I keep 16 credit cards open. Yes, SIXTEEN.

Which makes me either:

1. A complete idiot for opening 16 credit cards who is probably rolling in tons and tons of credit card debt that will absolutely wreak havoc on my life. Goodbye future dream home, future retirement, and my credit score. (PS – You should read about how having a good credit score is good for you at this link)

Or

2. Someone who knows how credit cards work and how to use them to your advantage.

Hopefully, I can convince you that it’s #2, but if you think it’s #1, you probably shouldn’t be reading my advice on personal finance right now. But before I teach you about its advantages, let’s first talk about how they work and why having credit card debt is bad. My goal with this article is to help minimize your contribution to the almost $1,000,000,000,000 in credit card debt in the United States. The average American should not have over $6,000 in credit card debt.


How do Credit Cards Work?

Right when you turn 18, somehow or another, banks catch wind of your transcendence into “adulthood” and start sending you dozens of emails and letters telling you that you are PRE-APPROVED for one of their credit cards. Now before you get all excited and sign up for that powerful piece of plastic, you should know how they work.  The best way to do this is to split it up into terms you’ll see on your credit card bill. Here’s the breakdown:

Easy to understand terms

Credit limit: The maximum amount of money that you can spend on your credit card without paying off anything. When you first get your credit card the financial institution who issues your card will judge (mostly with your credit score) how much money they trust loaning out to you at a given time. For most people who get a credit card, their limit is usually around $500 to $1000. If you are a responsible credit card holder financial institutions will slowly raise your credit limit over time.

Balance: Your balance is how much money you have spent that you have not paid off. Every time you make a purchase with your credit card, your balance will go up to reflect that purchase.

Available credit: This is how much money you have available to spend before you hit your credit limit. If your credit limit is $1000 and your balance is $300 you have $700 in available credit.

Essential to know terms

Billing cycle: A set period, which is usually a month, where all the purchases on your credit card are added together to make your statement balance.

Statement balance: The amount of money you have to pay your credit card company after a billing cycle to not have to pay any interest on your credit card payments. Once your statement balance appears on your credit card, you will be given a grace period of around 25 days to pay off that balance without it accruing interest.

Statement due date: The date that you have to pay off your statement balance before it begins to accrue interest.

Minimum payment: The amount of money you have to pay your credit card company in order for them not to charge you a late fee or ding your credit score for missing a payment. If a missed payment appears on your credit score, it can stay there for up to 7 years.

Credit card debt: The amount of money remaining that hasn’t been paid off from your statement balance after your statement due date. Your credit card debt is the amount that will rack up interest.

Annual Percentage Rate (APR): The percentage of interest a credit card company charges on your credit card debt. This interest rate is usually between 14-21% which is the percentage of interest fees you would accrue every year. This rate isn’t the most intuitive rate to know about your credit card, as interest is accrued on your debt every day, but it is an essential factor to figuring out how much interest you’re paying on your debt.

Daily periodic rate (DPR): The percentage of interest accrued on your credit card debt every day. This rate is found by dividing your APR by 365, the number of days in a year. If you have an APR of 17%, your DPR would be (.17/365) = 0.00047 = 0.047% of interest every day. So if your debt (statement balance not paid) is $2,000 you would pay $0.94 in interest for the first day of keeping the debt.

Note – Some nicer credit card companies accrue interest at a monthly rate, where the APR is divided by 12 instead of 365. Credit card companies discovered that they could make more money with a daily interest rate, so most have changed to a DPR. Check with your credit card company to see what method they use. The following examples will be using DRP.


Why having credit card debt is bad for you.

Just like I wrote about the magic of compound interest in investments, the same calculations happen to your credit card debt, except this time it’s how credit card companies make money off of you. Let’s go through a detailed example of how this would all play out.

Part 1: Alan’s credit card purchases and essential information

In this example, we use the fictional example of Alan, who made three purchases on his credit card from January 8th to 15th; he had no other purchases in his billing cycle at the time.

Here is some information on Alan’s credit card:

Billing cycleDec 13th to Jan 13th
Credit limit$5,000
Credit card debt
prior to Dec 13th

$0
Balance prior to
first purchase on Jan 8th
$0
APR17%
DPR 0.047%

Alan’s recent purchases:

Description of transactionAmountDate
Dinner and drinks with friends$40Jan 8th
New laptop$980Jan 11th
Electricity bill$120Jan 15th

Summary of credit card statement:

Balance$1,140
Statement balance$1,020
Available credit$3,860
Statement due dateFeb 9th
Minimum payment$20

As we can see in this example, the first thing to point out is what items Alan needs to pay off by the due date. Since this billing cycle is only from Dec 13th to Jan 13th only the first two purchase Alan made will show up on his statement balance, the balance that must be paid off by the statement due date to not incur any interest. The payment of his electricity bill on January 15th will show up in his next statement balance for the next cycle. Until the next cycle is done, Alan does not need to pay off this amount. Although, it will reflect in his balance and deduct from his available credit. This means that Alan must pay off the $1,020 from his statement balance by February, 9th to not be charged interest fees.

Part 2: Scenarios of paying off Alan’s statement balance, ranked from best case to worst case.

1. Pay off the full statement balance before Feb 9th.

This is the best case scenario, he won’t be charged any interest, and the credit card company won’t make any money from his transaction. In fact, if his card earns points, a whole other topic, he’ll benefit from using his credit card.

2. Pay off any amount between $20 and $1020

In this scenario, he pays more than his minimum payment, but not the whole statement balance. Which means that for whatever he does not pay off, the credit card company will start charging daily interest on his remaining credit card debt until he pays off this amount. So if he pays $520, and has a remaining statement balance of $500 that was unpaid, he will be charged 0.047% interest, which is about 24 cents, the next day. Which doesn’t sound like a lot, but if he chooses not to pay it off for a second day the credit card company will not only charge 0.047% of interest on the $500 he owed, but also on the 24 cents. So not only does the credit card company rack up interest on the money he spent, but it also racks up interest on the interest he owes! As you will see in our next example, leave this amount unpaid, and it will start to add up.

3. Pay off the minimum amount of $20 on his statement balance.

This leaves $1,000 of his statement balance unpaid. Which means that the credit card company will start charging 0.047% of interest on the $1,000 plus the interest it accrues every day. In a hypothetical scenario where he pays only the $20 minimum amount every month and not use his credit card for any other purchases (including the electricity purchase describe above), how long would it take to pay off the card?

Months to Pay Off88
Amount of Interest Paid$751
Total Amount Paid$1,751

On this $1,000 purchase, the credit card company would be making $751 from him if he chooses only to pay the minimal amount! In reality, this is how many people fall into the trap of credit card debt. The $1,000 purchase usually isn’t the end of it; the credit card company tempts him with his available credit to spend more. Sooner or later it won’t be $1,000 that will be accruing interest, but $3,000 or the full $5,000! During this whole time, the credit card company will be charging him a daily interest rate on both the amount he paid for something and the interest it has already collected. This is why credit card debt is so dangerous if you don’t pay it off. The 17% APR is a ridiculous rate, a rate that many investors dream off. But, for credit card companies this is their norm, and they make it off of regular people every day.

4. Not pay anything.

He (and you) definitely should not default on the credit card. The credit card company will charge him a late fee of around $35, which is more than what his minimum payment would have been and then proceed to hurt his credit score for seven years. To top it all off, he will continue to accrue interest on the full $1020 and will be a dangerous situation overall. If you ever see yourself in this type of situation, please ask for help! It’s a tough situation to be, but you aren’t alone. Feel free to reach out to us on our contact form for some help, and we will do our best to point you towards the right people.

(The goal of this project is to help as many people as we can with the basics of personal finance, please don’t hesitate to reach out.)

What’s the best alternative to credit card debt?

No matter what, the best piece of advice I can give you is to not use your credit cards on items you can’t pay for. However, if you do already have debt, you should be doing your best to aggressively pay it off as soon as possible. If you feel suffocated with your credit card debt and don’t have the money to pay it off, you should look to refinance. You probably see this term in a lot of commercials, but the gist of refinancing is to take out another loan to pay off your credit card debt. Usually, financial institutions will offer a lower interest rate on a loan that can fully or partially pay off your debt. You would then make monthly payments to the financial institution that gave you the loan instead of the credit card company at a much lower interest rate. If you think you can benefit from this, you should talk to a financial advisor as soon as you can. Let’s make it happen!

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