Balance vs. Monthly Payment
Have you ever wondered why your card balance is so low, but your monthly payment is so high? It’s because your monthly payment is based on your balance plus the interest you owe the credit card company. The interest you pay is based on your APR and the average daily balance you carry on the card. On average, you are being charged about .04% in interest everyday you carry a balance. It might seem like nothing, but if you carry a high balance, the interest you owe becomes significant.
The credit card company quotes you an APR, but in actuality it is charging you interest on a daily basis. This daily balance calculation is what ends up affecting your monthly bill. Therefore, you should become familiar with the following terms:
APR = Annual percentage rate. It’s the yearly interest you will have to pay on the money you borrow on your credit card. For example, many credit cards charge an APR of 18%.
Average Daily Balance = Your previous card balance plus any payments and charges you made throughout the month.
Credit Card Example
To understand how APR and average daily balance work together to become your monthly bill let’s use an example –
It’s December and you have a credit card with an APR of 18% and a previous balance of $500. On the 15th of the month, you make a charge of $50. Then on New Year’s Eve, you go out for drinks and charge another $100. At the end of the month, you have total balance of $650.
|Day of the Month||Purchases||Daily Balance||Number of Days with Balance|
In this example,
Daily APR = (18%/365) = .04%
Monthly APR = (18% /12 months) = 1.5%
Average daily balance = ($500 *14 + $550 *16 + $650)/31 days = $531
Monthly interest = ($531 * 1.5% *1) = $7.96
Your next bill for January will be = ($650 + $7.96) = $657.96
Minimum payment= ($657.96/36) = ~$19
Check out this great video that will help explain the math = Credit card calculation
Making minimum payments will stop you from getting hit with late fees, but it does little to reduce your bill. Paying the minimum is just like getting paid minimum wage. You are allowed to do it, but no one should actually strive for the minimum.
In this example, you know the minimum payment that the credit card company is expecting is $19. However, if you choose to pay the minimum payment, only $11 out of the $19 will go to reducing the money you owe. That means more than 40% of your monthly payment will be used to pay interest!
In addition, say you never made another purchase again with this card and only paid $19 every month. It will cost you over $200 in interest and take you years to pay off the card.
If you are late on a payment, you will get hit with a late fee. Late fees are bad for three reasons:
- It’s a pretty big penalty that will get attached to the overall balance of the card.
- It will have a negative effect on your credit report.
- The credit card company will most likely increase your APR, because you are now seen as a higher risk.
All cards are not the equal
The cards with the highest interest rates are usually store cards (Macy’s, GAP, Target, etc.). These companies offer huge store discounts to entice you to put things on your card. However, if you do not pay the balance off when the bill is due, you will have most likely lost all of the discount you received from the sale. You will end up paying more than you would have had you just paid full price at the beginning. Department store sales are tempting, but it’s one of the quickest ways to get into debt.
What to Do
The best thing to do is not use a credit card. If you do use your credit cards, make sure you either pay them off in full at the beginning of the month, or at least make more than the minimum payment. If not, you will find yourself with never ending bills.
We would love to hear if you think this was helpful. Let us know in the comments below!
Nadia is a Financial Independence Coach from New York City. She holds a B.A from Columbia University and worked 13+ years in Investment Banking and Financial Services. She is an entrepreneur, investor, and partner at Wealth Twins LLC. She reached Financial Independence in her 30’s and is passionate about showing others how to achieve the same.