Sunday, January 6, 2008

Why Credit Card Interest Rate Is Not Just An Interest Rate

Credit card companies hope you want a credit card to shop until you drop, but they certainly don't want you shopping around for the best deal on them. In terms of borrowing money, to do so on a credit card is one of the most expensive ways possible. The interest rates on credit cards for the most part exceed those of student loans, mortgages, and car loans. Only payday loans are more egregious. It is the interest rate that you need to shop around for, but it's not the final rate you need to look at. It's how it's calculated that counts.

When you buy clothes in NYC, the first $100 spent is tax free. Say you go out and buy a dress for $280. When you pay tax, wouldn't you want to know if you are paying tax on the full $280 or just the $180 after the first $100 is tax free? The same goes for interest rates on credit cards. How you get nailed by a number followed by a percentage is important. A credit card's interest rate is that ominous number that carries around its fine print baggage wherever it goes. Not that anyone would want to read that fine print. But not doing so can cost you major money, because you might not realise that you're getting killed by what you thought was a benign interest rate. Because an interest rate is an interest rate, right? Really, now, you think credit card companies are that easy...

Your APR is your Annual Percentage Rate. In other words, APR=interest rate, and all credit cards must by law disclose their APR. But notice the word annual in that acronym. So to charge you your interest on that flat screen TV you just had to have but can't afford to pay off in full at the end of your billing cycle, the credit card company can't charge you an annual rate for a monthly charge. So instead they calculate the finance charge using the Periodic Rate, which is the APR divided by the number of billing cycles per year (usually 12). So let's say your $1000 flat screen was charged to a card with an 18% APR. 18 percent annually divided by twelve billing cycles in the year equals a Periodic Rate of 1.5%. This is what you are charged each billing cycle. Now the fun begins.

There are several ways to calculate the interest rate. The most common are Average Daily Balance Method, Adjusted Balance Method, and Previous Balance Method. To stave off head splitting boredom, I'll use our $1000 flat screen TV scenario as an example for each method. So for all the following examples you have a beginning balance of $1,000 on an 18% APR credit card, and pay $800 on the 15th of the month.

Average Daily Balance (most common)-

    Balance $600 ($1,000 for 15 days, $200 for 15 days)
    Finance Charge $9 ($600 x 1.5%)

Adjusted Balance (best)-

    Balance $200 ($1,000-$800)
    Finance Charge $3 ($200 x 1.5%)

Previous Balance (worst)-

    Balance $1,000
    Finance Charge $15 ($1,000 x 1.5%)

You can find a mathematical explanation of how credit cards calculate interest rates here, but suffice it to say that you need to read your fine print. Look online under terms and conditions, or just call the toll free number on the back of your card and ask what method your card uses for the calculation of finance charges. And while you're at it, make sure you have an interest free grace period of 25-30 days. Cards with grace periods are getting fewer by the minute, and frankly nobody should have one without a grace period. It shouldn't cost you to pay off your balance in full each month. I mean, just look at how much it could cost you not to...

5 comments:

SavingDiva said...

If my credit card stopped offering an interest free grace period, then I would stop using the card!

Thanks for the breakdown. I didn't realize that they use the average daily balance to charge interest. I thought they would just use the remaining ($200 in your example) amount...

Ms. M&P said...

GREAT post. This is really helpful. I immediately started calculating all my interest rates, which are average daily balance. Man, I wish I'd known all this five years ago!

PiggyBankBlues said...

SD- i thought the same thing about how to charge interest, and was like this is so crazy when i learned it was mostly done other ways...

m&p- welcome back :) piggybankblues has been a little more blues without ya!

Anonymous said...

Thanks for the article - very helpful. My one question is, which cards offer adjusted balances? I've heard those are hard to come by and that the majority of cards use avergae daily balance.

Amanda said...

I feel the best way to handle credit cards is to pay them off at the end of every month. There is nothing worse than credit card debt. It becomes a nasty thing because you will only continue to add more and more to the bottom line. If you vow to only buy what you can pay for at the end of the month, you'll not only have less debt but you'll be much happier for it.

Amanda,
Checks Unlimited