The Big Reveal – Credit Card Interest

The consumer culture has become a complicated and complex place to live. Dealing with money is no longer simple and straightforward, and it’s easy to make financial mistakes that haunt us for years. Despite the focus on finances during Financial Literacy Month in Canada, insights to help us navigate through the system are fragmented and inconsistent.

Credit Card

For many years I taught a college course in consumer issues and economics. Early on, I discovered that most students thought if they made the minimum monthly payment on their credit card, they weren’t in debt. They used their credit cards freely and paid the required minimum each month. They thought they were doing the smart and adult thing. Sadly, they weren’t.

After reading a recent report about the financial literacy of Canadians, I decided to pose a question about credit card repayment on social media. It included a link to a one-question survey where respondents could register their answer. Here’s the question…

Chris has returned from a fabulous 27th birthday vacation. The entire trip was paid for with a credit card intended for that purpose only. The vacation cost $4268 and the card will never be used to buy anything else. Chris has vowed to make the minimum payment each month, without fail. The first payment is $43 and the annual interest rate is 20%. How old do you think Chris will be when the last payment is made?

So…how old will Chris be?

The choices were 35, 40, and 49 years old. If you haven’t answered the survey, take a moment to think what you would have said.

Drum Roll

The answer: Chris will have just turned 49 when the last payment is made. It will take 21 years and 11 months to pay for that birthday trip.

How do I know this?

Canadian legislation requires the lender to include a section on monthly credit card statements that indicates the estimated time to pay the balance in full. It’s usually in small print and not always as easily found as the one shown below.

Credit Card Estimated Time to Pay

This image is a scan of part of the  monthly statement used in Chris’s story. As you can see, when making only the minimum payment each month, it will take Chris 21 years and 11 months to fully pay off the balance.

What the statement doesn’t tell us…

  • The estimated length of time assumes there are no further charges on the card. If there are, that will increase the minimum payment and the length of time to pay off the balance.
  • Their estimate assumes that the payment is always received by the due date. If it isn’t, there will be various late fees and interest penalties, depending on the lender. Even one late payment can cost a lot.
  • They are not required to tell the card holder how much money will be paid in interest over that time period.

Finding out how much interest you will be paying…

How much interest? It’s an important question, so I found an online calculator and entered the numbers from the statement. I got a message back indicating it couldn’t be calculated with those inputs. I went to another, and another, and another, and yet one more. Each came back with a similar message, usually in red or highlighted in yellow. Here are two examples.

  • Sorry, but the minimum percentage of balance paid must be greater than 2.68% in this particular case, otherwise it will not be paid off in reasonable time.
  • It is unlikely that you can pay off the balance with a monthly payment of $43. You will need to pay an amount higher than $71.10.

When I eventually found a calculator that actually did the calculation on the basis of the statement details, it reported that it would take 50 years to pay off the debt and total interest paid would be $565,595.10. But that wasn’t helpful either, because this length of time is more than double what the credit card company estimated on the statement.

In the end, I resorted to a manual calculation of interest.  I used the basic formula for simple interest. This is accurate enough to give us an idea of what the interest would be for the first month. However, since credit card interest is typically compounded daily, this wouldn’t be accurate for calculating the final total amount over almost 22 years. In the formula below, APR is the Annual Percentage Rate, and was 19.99% on the statement I used.

$ balance   x   APR/100  =  $ interest per year

$4268  x 19.99/100  = $853.17 interest per year

To calculate interest per month, simply divide by 12…

$853.17/12 = $71.10 interest per month

How can it be that Chris owes $71.10 in interest and is only asked to pay $42.68? Chris is underpaying by $28.42.

Call me cynical, but I seriously doubt that the credit card company is going to overlook that amount. More likely, it will be added to the balance. So the next month, Chris will owe $4296.84 (i.e. $4268.42 + $28.42).

And the cycle of adding unpaid interest to the principal (balance still owing) would continue unless Chris increased the payments substantially beyond the minimum they are asking for. No wonder the online calculators said that this debt could never be paid off!

Other examples of estimated times

Since calculators weren’t a lot of help, I made a chart showing estimated times to pay off varying balances. These are all taken from existing credit card statements in 2017. Interest rate is 19.99% in each case.

BalanceMinimum PaymentEstimated time to pay off in full
$421.14$15.003 years and 2 months
$263.71$15.001 year and 9 months
$2,782.08$27.8218 years and 4 months
$1,170.60$10.009 years and 4 months
$4,268.42$42.6821 years and 11 months

The big takeaway

It’s a waste of time to try to figure out how to manipulate credit card charges to your advantage. The deck is stacked against you.

Below are a couple of places where you can fill in the information gaps and learn as much as, or possibly even more than, you really want to know. Both of these are sites built by people who have experience to back up what they are saying.

They are American, so some terms and legal details may be different for those of us outside the US. One is regarding credit scores. In the US, FICO is the name for the most well-known credit scoring system. In Canada, your credit score is reported by TransUnion and Equifax. Nevertheless, basic information usually applies everywhere.

Credit Card Insider has an in-depth section called “Learn.” To understand minimum payment and interest calculation in detail go here.

Financial Mentor is more about overall strategy than specifically credit cards. There is a section of calculators for all sorts of situations including mortgages, car loans, compounding interest, and so on.

Next week: Why I don’t care what the interest rate is on my credit card. Until then…

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