Monday, May 21, 2007

How credit card interest works

I was quite surprised reading around at other blogs, and after watching the senate committee meeting with credit card companies, that many people do not understand just how their card charges them interest.

It appears many people believe that when their bill comes, they pay interest on any balance they have left over. I have a $500 balance, I send them a check for $400, and my rollover balance is $100, which I pay 15% interest on. Sounds good for me the consumer, but its incorrect.

Credit cards calculate interest based on the average daily balance of the card during the billing cycle. If I make a $500 charge at the beginning of the period and pay $400 at the end of the period, I end up paying interest on around $500. Not $100. This makes a lot of sense. I am paying interest on the amount that I borrowed, not the amount of balance that I am carrying over 30 days.

If however, I pay the balance in full, I will not be charged any interest at all. This is great for 'deadbeat' card users like me, because even though I've borrowed money for almost a month, I don't have to pay for that privilege.

If by some chance I could not pay the full balance at the end, my effective interest rate would be far less on what I borrowed as well. This is because when I use my card, I often pay it down weekly, not monthly. Therefore my average daily balance at the end of the billing cycle will be far less than $500, even if I had purchased $500 worth of goods and carried a $100 balance to the next billing cycle.

This is all explained in the terms and conditions. That fine print brochure they give you is indeed readable, but it does take time to sit down and go over it. And why wouldn't you? You are entering into a contract with a company to handle currency transactions for you - why would you not insist on knowing every term in that card? Even if you do not understand it, the customer service number is there to call with questions.

Know your card, know what kind of contracts you are entering into.

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