For me, credit card interest rate is a non-issue. I use my card as a convenience and for the cash-back feature. I never use it as a means of living on borrowed money.
The paradox of credit cards…
Why you can’t win when you pay interest on a credit card…
As long as there’s a balance on your credit card, you are in debt. The lender requires you to pay interest for the use of that money. Credit card companies are happiest when you pay the bare minimum, because that extends the time you are making payments. The longer the time you are paying, the more interest they get from you. The table below illustrates the effect of time using two different credit card balances. In each case, we see that the higher the monthly payment, the shorter the time to repay the loan.
| Card Balance | $ Paid Monthly | Time to Pay It Off in Full | Interest | Principal | Total $ Paid |
|---|---|---|---|---|---|
| $421.14 | $15.00 | 3 yr 2 mo | $151.37 | $421.14 | $572.51 |
| $30.00 | 1 yr 5 mo | $62.59 | $421.14 | $483.73 | |
| $100.00 | 5 mo | $19.33 | $421.14 | $440.47 | |
| $1170.60 | $25.00 | 7 yr 8 mo | $1,120.72 | $1170.60 | $2291.32 |
| $50.00 | 2yr 6 mo | $325.41 | $1170.60 | $1496.01 | |
| $100.00 | 1 yr 2 mo | $142.46 | $1170.60 | $1313.06 |
Seriously? That much?!
To understand why we pay so much interest, we need to think about the compounding of money. Somewhere back in a math class, we all learned about the magic of compounding interest—taught in the context of saving and investing. The “magic” is that the amount of our investment increases exponentially over time because our interest is added onto the principal, meaning that year after year we are paid interest on our interest. The longer this process keeps repeating, the more “magic” we experience. Financial Mentor has lots more about compounding, including a calculator.
We like it when we’re on the receiving end of interest payments. But few of us make the connection that the same compounding principle applies when we have borrowed money instead of invested it.
When you have an outstanding balance on a credit card, compounding is working in reverse. You are paying compounding interest rather than receiving it. The lender is the one being paid interest and benefiting from exponential growth. That’s why small monthly payments and long loan repayment times are an advantage for credit card companies. For us, the borrowers, not so much.
The way to avoid the debt burden is to pay the balance in full each month by the due date, no exceptions. If you’re in a spot where you’ve gotten into debt beyond what you can pay off every month, there are good strategies to help you get out from under the debt load.
What to do if you’ve been carrying a credit card balance…
- Stop using the card. Additional purchases only increase your debt load and the time it will take to pay it off.
- Tighten your belt. Commit to living on less than your income. Make a list of places where you can cut back spending.
- Look at your income and expenses. Figure out how much you can find to add to the payment on your card each month.
- Use a debt repayment calculator to see when you will pay off the balance with that amount (from step 3) added to your monthly payment.
- Repeat steps 3 and 4 until you have found every possible extra bit of money to put on the card each month, even if it means taking lunch to work, not buying fancy coffee, etc.
- If you receive any extra money such as birthday cash, proceeds from selling used items, or a GST refund from the government, immediately use those amounts to pay down the card. These extras will significantly shorten your repayment time
How we got into this mess…
I’ve lived long enough to remember the days when banks asked a woman to bring in her husband to cosign for her credit card. True story. It happened to me.
That was the early 1970s, when Visa cards first came along, called Chargex back then. In those days, banks were cautious about issuing credit cards unless they were confident the person had the financial means to cover it. Things changed when the lenders discovered what a money machine credit cards are.
When I started teaching consumer economics, college students could not get a credit card until they were at least in their second year, and then there were some pretty strict conditions. Somewhere along the way, credit cards began being pushed at first-year students. At my college, it became common to see a bank kiosk in the main hall promoting sign-up for credit cards, and one day there were credit card applications on all the desks in my classroom. As I pointed out to my students that day, it was very clever of credit card companies because, as all pushers know, the younger you get them hooked, the better.
Shortly after that, cards began having additional perks to induce us to use them more. Insurance on items you buy with the card. Insurance on you when you use the card while traveling. Points for all of your purchases so you can get more things or trips. And then they started offering a small percentage of cash-back on some purchases.
In terms of credit mindset and behaviour, credit cards went from something that was used with careful thought to a means of paying for everything we buy. The problem is that credit card use has got out of hand for many, and the resulting debt becomes a downward spiral that keeps people evermore indebted unless they figure out how to extricate themselves.
There’s an important distinction that has been lost—and it’s at the root of over-indebtedness. This is the distinction between using a credit card as a method of payment and using it as a means of borrowing money. The difference shows up in how you manage your payments.
If you pay the balance in full every month, you are using the card simply as a method of payment instead of cash or a debit card at the time of purchase.
If you pay less than the full balance, you are borrowing money because you don’t have enough in the bank to use cash or debit for your purchases. In that case you are using the card as a means of borrowing money.
That’s the basis of the paradox of credit cards. A credit card is completely free when you choose one with no yearly fee and use it as a method of payment. It’s very expensive if you use it as a means of living on borrowed money and paying an interest rate of 20% for the use of that money.
Beat them at their own game…
Until the lenders change the rules of the game, here’s what you can do:
- Use your card as a means of payment if you want the convenience, points, or cash-back.
- Keep track of how much you’re spending on the card so you don’t exceed the amount of cash you have available to pay it off.
- Pay the balance in full by the due date each month.
Loan consolidation is another big trap…
If you have several cards and other loans that you pay off in small monthly amounts, do not consolidate them. It can sound tempting to lump all your debt together and make one smaller monthly payment. But this is usually a recipe for disaster.
People who consolidate typically end up paying even higher interest rates than they were on their individual loans. And that “smaller monthly payment”? Smaller payment = longer period of time required to pay it off. As we’ve seen, that means paying a lot more total interest before the loan is paid off.
A consolidation loan is only an advantage if the interest rate is lower than on the original loans, and if the monthly payment is at least as much as the combined total of all the monthly payments on the individual loans. Only consolidate your debt if you have expert guidance from a trustworthy person who is in no way profiting from your consolidation loan.
Resources…
Snowballing is a much better option than consolidation because it’s a plan to help you get ahead, not fall behind. Snowballing is a method of quickly paying off individual loans by adding extra money to your monthly payments in a planned way. You’ll find lots of snowball calculators if you do an Internet search. Some are easier to use than others. Undebt.it received lots of good reviews. Here’s how the company describes it.
“Undebt.it is a free, no-strings-attached service that will use the debt snowball, avalanche or your own custom payment method to finally get you out of debt. My main motivation for making this site public (and free) is that I wanted to make the tools that work for me available to everyone. Interest paid on consumer debt is wasted money, plain and simple. The sooner you get out of debt, the sooner you can start enjoying life a little more. Have some fun and live debt free!”
Gail Vaz-Oxlade spent more than a decade handing out no-nonsense advice to Canadians about family finances and unmanageable debt. Though recently retired, she has left behind a website, several books including Debt-Free Forever, a blog, and lots of videos on YouTube.
All of these resources are worth exploring if you want some ideas about what’s possible. Then it’s up to you.