Calculating The Damage

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Regular readers know that I am a devout “deadbeat”.    That is credit card industry slang for someone who avoids paying interest and fees by ALWAYS paying his credit card bill in full and on time.   Not usually, not most of the time, but EVERY SINGLE MONTH for my entire life.   In the rare case when a technical glitch prevents my payment from being received on time, I have successfully asked for all interest and penalties to be waived.

That said, I am always trying to understand why the majority of credit card holders pay interest every month.    There appears to be several reasons.    I have come to the conclusion that most people do not have the slightest idea how banks charge them interest on their credit cards.  I don’t blame them.   The methods banks use to charge interest on your credit card is very complex, and one could argue that they do this on purpose.  It seems more likely that it’s complexity was merely a side effect that was was created when they designed a system to collect the maximum interest for a given rate.

Let’s Take  A Look

Most people imagine that because they can pay their credit card in full and pay no interest, that the interest does not start accruing until after their due date.   In fact, from the credit card company’s point of view, interest begins accruing from the moment you make the purchase.   That interest is then waived if you pay off your entire balance in full by your due date.   Pay one penny short of your balance, and you will owe interest on each purchase from the time of purchase to the time payment is received.   The explanation is woven into the fine print, yet it comes as a surprise the first time you see how much interest you owe on the bill following the one where you didn’t pay your balance in full.

For example, imagine you have just received a new credit card.  If you were to charge $1,000 to your credit card in May, and pay $900 of it when the bill is due in June, your next bill will have interest charges reflecting interest on the $900 from the date of purchase until the date of payment, as well as interest on $100 from the date of purchase until the date of the next statement.

It gets worse.   Because you failed to pay your balance in full, any additional charges that you made since that original $1,000 charge in May are going to continue to accrue interest from the moment you make the purchase up to the day all charges and interest is paid in full.    Every cup of coffee, every gallon of gas, and every loaf of bread is going to ultimately cost you more than you appear to be paying when you swipe your credit card.    Even if you come up with the cash to pay the entire balance by the due date, you will still see interest on your next statement from the time the last statement closed  until the payment was received.    If you make any more purchases between when the statement closes and when your payment is received, you still continue to accrue interest until such time as you truly have a zero balance.

As bad as this sounds, it was actually much worse until February of this year.    Before that time, banks were free to employ “double cycle billing”, a scheme that as far as I know only applied to credit cards.   This truly despicable practice allowed banks to charge you interest on the average of your last two billing cycles.   In effect, you were paying interest on the balance that you had already paid off.   Imagine if you went to the supermarket and purchased a lobster tail for $20.    The next day your returned to purchase ramen noodles for 18 cents, and the cashier asked you to pay $10.09, the average of your current purchase and your last purchase.     That is exactly what credit card companies got away with for decades before the CARD Act went into effect in February of 2010.

Figuring It Out

One feature of the CARD Act is that your statement now shows how many months it will take you to pay off your balance if you pay the minimum, and how much you will end up paying in the end.    I recently came across a web site called The Real Damage that attempts to calculate the same thing.    Using these tools, you can see for yourself how financially damaging it is to pay interest on your credit cards.

http://en.wikipedia.org/wiki/Credit_CARD_Act_of_2009

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