Percent of Balance Owing
Credit card companies will determine the minimum payment on your next credit card statement as $10 or a percentage of your outstanding balance, whichever is greater. Most financial institutions will use 2% and more conservative banks might use 3%. Your minimum payment would then be ‘$10 or 2% of your outstanding balance, whichever is greater’.
So how does the way they calculate minimum payments affect how much you pay? Who cares if they use 1%, 2% or 3% of the balance owing?
Let’s look at 2 examples, each with a $5,000 credit card balance @15% APR, but with different minimum payment requirements. Assuming you were only making minimum payments in both instances, this is how long it would take:
If the minimum payment is 2% of balance owing it would take you 32 years and 1 month to pay off and almost $8,000 in interest. Increase the percentage to 3% and you nearly cut your repayment period and interest expense by half to 16 years and 5 months and just over $3k in interest. To unsuspecting borrowers, reducing the percentage can cause more financial harm than increasing the interest rate in many cases.
So what might be an alternative solution?
Ideally you want to make fixed payments each month. A fixed payment is the best option because as the debt is paid off, more money goes towards the principle.
Alternatively, you can determine your own ‘percentage of balance owing’ and use this amount for your monthly credit card payment each month.
Let’s say you decided to go with 5%. Using the same example as above a $5,000 credit card debt at 15% interest rate. Monthly minimum payments is $10 or 5% of outstanding balance owing, whichever is greater. By increasing your minimum payments from 2% to 5% of the balance you would be able to pay off the loan quicker.
If paying off your credit card debt is not a top priority, then setting your own ‘percentage of balance owing’ slightly higher than the banks might serve as a good middle ground between making the banks recommended minimum payments and a fixed payment amount each month.
Below is a comparison between making payments of 5% of balance owing or a fixed amount of $250/month. The fixed amount wins out but the 5% option will still leave you better off than the previous comparison.
Daily interest rate
Interest expense on a credit card balance is compounded daily. Every day that you have a balance owning on a credit card (outside of the grace period), your bank is calculating interest on interest and this can add up. Most credit card companies express the interest rate as annual percentage rate (APR). However, because interest expense is compounded daily, the actual interest owed is higher. If you convert how much interest you would actually pay into a percentage, this would be called the effective annual rate (EAR). I have talked about the difference between APR and EAR in a previous post. Below is a table of sample interest rates and what they truly cost. I used this calculator to do the conversion.
|Annual Percentage Rate (APR)||Effective Annual Rate (EAR)
Knowing how interest rates are compounded will help provide a better picture of the true cost of borrowing.
I got my first credit card during my second year of university. When it arrived in the mail included in the package was a credit card holder agreement as well as five cheques for me to use. I was a bit confused because I always associated cheques with a bank account like a chequing or savings account. I never knew you could write cheques from your credit card. I proceeded to read the fine print document that accompanied the cheques. ‘Writing a cheque from your credit card is considered a cash advance’ (I’m paraphrasing). This was when I was first introduced to the concept of a cash advance.
Cash advances typically charge a higher interest rate and the interest starts accruing right away. There is no grace period for a cash advance. Whether it is writing a cheque or getting cashback, anything outside of a point of sale purchase with your credit card is considered a cash advance.
Consumer debt like credit card debt and unsecured line of credit (LOC) are callable debt. Callable debt is debt that the lender can request to be paid back in full within 30-90 days, period. That is a little scary. Granted, because creditors prefers that you keep your debts outstanding for a long period of time so you can pay them more interest, they most likely will not exercise that right. Knowing this however has helped me gain perspective on who really holds the power in a business transaction between a borrower and a lender. The borrower has options when searching for credit and lenders may work to win their business. However, once they sign on the dotted line and indebtedness begins, the borrower is truly slave to the lender.
Grace period is the time period when interest is not charged on credit card purchases. This time period is usually 21 days. Grace period only applies to those that pay their balance in full each month. Those that keep a balance will not receive a grace period.
Let’s say for example you received your first credit card in the mail and purchased $200 worth of merchandise. Later on you receive your first credit card statement online with the $200 balance owing. Your statement date is June 1st. Your payment due date is June 25th. If you pay the full $200 by June 21st, (your 21 days of grace period) you will not incur any interest on this debt. If you pay any amount less than $200 (the full balance owing) the interest expense will be calculated from the first day you made the purchases up until you pay the debt back in full.
On a larger scale grace periods are similar to the buy now and pay later furniture and electronic store campaign. You may walk into a furniture store and pick out an entire living and dining room set, get 0% interest financing for the first year, make no payments towards your debt and start paying after year one. However, your first payment one year from now will include your principal balance plus a years’ worth of interest expense. Those that understand this utilize the 0% interest financing and pay off the entire debt before their promotional interest rate of 0% is over. Those that don’t pay a hefty price. Grace periods work the same way but in a much smaller scale with shorter time frames and lower interest rates.