Credit cards can be great. When used responsibly they’re convenient, allow you to purchase goods from overseas and let you earn lucrative rewards such as cash back and airpoints. When used irresponsibly however, credit cards can cost you big time in interest, digging you into a hole that’s hard to get out of.
Total outstanding consumer debt in the US for 2016 was a staggering $3.4 trillion dollars. The average credit card debt among American households in 2016 was $5,700. If you adjust for the card holders that pay their cards off in full each month (i.e. the average balance-carrying debt) the average is $16,048! The worst part is it that those households with negative net worth have disproportionately higher credit card debt compared with their positive net worth counterparts.
This evidences that there are many households out there that are getting deeper and deeper into debt with an increasingly difficult road ahead to get them back in the black.
Understanding Interest – APR/APY and the power of compounding
As I mentioned before, credit cards can be a great tool when managed correctly. The secret to managing credit correctly is to understand the expenses involved and to reduce, if not eliminate, the interest that you pay on your credit card. We’ll talk about strategies to do that soon, but for now have a look at the calculator I’ve developed below. I’ve explained the calculators inputs and how it all works in the following link.
*Note that the calculator isn’t mobile friendly yet- we’re working on it, but for now you’ll have you use a browser.
Have a play around with the numbers and you’ll see that the interest rate and fees, and how often they’re charged have a huge impact on both how long it takes to pay back a balance and how much interest you’ll pay over the lifetime of the debt.
What is APR and How Does it Work?
The key figure here is the ‘APR’ or the Annual Percentage Rate. This number represents what’s called the ‘nominal interest rate’. This is simply the interest rate, multiplied by how many periods in a year that it’s charged. For example, if your credit card carries an interest rate of 1% per month, you have an APR of 12%. The APR also includes any additional fees charged by your credit card company. If your card has a balance of $10,000 and incurs an annual fee of $100, this will add a further 1% to your total APR.
For simplicity, the above calculator assumes a fixed APR- in reality if credit card fees remained the same as the total balance went down then your APR would increase rapidly. This is because your fees compared to your outstanding balance would be proportionately higher. That’s why if you plan on carrying a low balance or paying of your card in full every month, you should look into credit cards with no or low fees. Even if you’re paying off your card, you’re still paying a form of “interest”.
It’s critical that you understand APR and the impact it can have on your credit card balance. When we think of interest too often our minds jump to conclusions. We might see cards with rates of 3% and 5% and immediately think the 3% card is the better option, however, depending on how often the interest rates are charged, we could be very wrong:
Consider a $10,000 balance, with monthly repayments of $500
At an interest rate of 5% charged annually the loan has an APR of 5% and will be paid off after 21 months incurring interest of $463.
At an interest rate of 3% charged monthly the loan has an APR of 36% and will be paid off after 31 months incurring interest of $5,500.
As you can see, this difference is absolutely critical to understand. Fortunately, most jurisdictions now require that a credit card carrier discloses the cards APR making them much easier to compare. If you’re ever unsure, just come back and use this calculator .
The Difference Between APR and APY
While APR is simply the interest rate (including fees) multiplied by the number of times the interest is charged in a year, APY takes into account another import factor, compounding interest.
Compounding interest represents the interest charged on the interest you’ve already been charged
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
If one of the greatest minds in history calls compounding interest the eighth wonder, it’s worth taking it on board. When compounding interest is working for you it’s an incredible wealth building tool; when it’s working against you it will kill your financial position, plain and simple.
Take another look at the calculator above. What happens when our monthly repayments fall below a certain level? Our total balance goes up. What would it look like if we graphed our balance over time?
not only does the balance get increase, but it increases at an increasing rate. If your repayment rate falls to the point where you’re not paying off the interest amount, the balance over time gets steeper and steeper until it’s almost vertical. This is because you’re paying interest on the interest and then interest on that interest and so on. It’s theoretically a never ending cycle. It’s easy to see how people get themselves into positions where they find it almost impossible to pay down their debt.
Now we’ve talked about how interest, APR and APY work, let’s talk about strategies you can use to reduce, or better yet eliminate credit card balances and interest payments.
1.) Never Pay Just the Minimum Monthly Repayment
Credit card companies want you to pay back the minimum amount (usually a few percent of the overall balance) because this is how they make money. If you’re making minimum monthly repayments and your interest rate is charged monthly at a higher rate, your balance is going to get bigger every month.You should always aim to pay off your balance in full every month. If this is unachievable, focus on paying it back as soon as possible. This is a very common sense approach however often the simple answer is the right one. There are certain situations where paying back interest-carrying debt isn’t a good idea, for example, when you can reliably reinvest the money for a greater return. This is almost never the case with credit cards because of how high the interest rates are. With credit cards you’re paying for convenience, they should never be used as a form of medium or long-term finance.
2.) Rank Your Debt by Interest Rate and Pay the Higher Rate Balances Off First
Even if your balance on lower interest rates cards is higher, pay off the higher interest cards first. This is because for each dollar paid back, the avoided interest expense is higher. You can then apply this avoided interest to your lower balance cards. This is the fastest and most effective repayment strategy.
3.) Call your Credit Card Carrier and Negotiate a Lower Rate
If you’re having trouble paying back your credit cards, get in contact with your bank and try to negotiate a lower interest rate. Why would the bank want to lower your interest rate? The bank wants to make money, if you default on your credit and never pay it back they lose big time. Banks don’t want this, it’s much more profitable for them to lower your interest rate slightly than it is to potentially lose all interest entirely and the original loan amount.Don’t underestimate this strategy. Have a look at the results of the calculator even with just a slightly lower rate. If you feel like you’re in a bad place with debt, I would encourage you to ask for a lower rate, there’s absolutely nothing to lose. The worst they can say is no.
4.) Consolidate You Cards into one Loan
If you have multiple credit card debts or other loans, you can potentially consolidate all of it into a loan account carrying a lower rate. Debt consolidation is only a good idea if you can achieve an overall lower APR compared to your existing debt. Don’t forget that there are sometimes upfront fees in debt consolidation which need to be factored in to your decision. Many loan providers will offer you this service for free however as they will still profit from carrying your loan and charging you interest. Many people choose to consolidate expense debt such as credit cards with their home mortgage which is usually at a significantly lower rate than credit card debt.One other thing to consider is that consolidated debts are often over a longer term. This is an issue because even at a lower interest rate you might end up paying more in the long term. Once again, the calculator above can be used to forecast what your total interest expense will be over the life of the consolidated loan.
5.) Develop a Budget, Stick to It and Apply Your Savings to Your Credit Card Debt.
There are a million and one ways to save money. When we don’t have a budget in place it’s often quite hard to realise just how much money we are wasting. Every dollar you save is a dollar you can apply against your credit card debt, and every dollar repaid is interest that you’ll no longer have to pay.List your monthly income and all of your monthly expenses. Often it’s not easy to increase your income quickly, however you can make changes to your spending habits immediately. Consider every single expense on the list and ask yourself the following questions:
- Is this a luxury I could do without?
- Is there a cheaper way I could be doing this?
Use this method to free up cash flows which can be applied to your high interest debt. Make sure that when you budget you put together something you’ll actually stick to. Just like a diet, it has to be realistic otherwise you’re likely to fall off the wagon.