By Julie Rasmussen
What’s your APR?
If I asked you right now what the Annual Percentage Rate (APR) on your most used credit card is would you be able to answer?
If not, join the crowd. Most of us wouldn’t be able to. Most of us sign up for a credit card because our bank offers us one or we respond to an offer we get in the mail. Occasionally, or more and more often, we may seek out cards online based on their rewards programs or an ad we see online or on TV.
And, if you pay off your monthly credit card balance in full each month, then you don’t have that much to worry about. Until you do. Until for some reason or another, maybe you don’t pay it off that month.
If you’re like the 44% of American credit card holders who keep a monthly balance on their credit card, the monthly interest on your credit card balance adds up quickly.
That can really start to bite.
The average credit card holder tends to have more than one card including store cards. The average monthly balances held on these cards is more than $5,000 per person.
So let’s see just how big a bite that APR adds up to.
If you had a balance of exactly $5,000 and a straightforward Annual Percentage Rate (APR) of 25% you’d pay $1250 in interest for the year. That’s a lot of dosh.
However, it’s not that straightforward. Did you know that most credit card companies calculate the interest on your outstanding balance DAILY? And then they add that interest to your outstanding balance.
So then you’re paying interest on your interest. That’s why if you read the fine print on your statement each month it will tell you that it will take you more than 14 years and you will end up paying more than $13,000 if you just pay the minimum payment each month.
If you just keep paying the minimum monthly amount due each month, you’re barely covering the interest charges from the month before, leaving very little to reduce the amount of the original charges and principal balance.
And if you keep using the card without paying it off, the outstanding balance just continues to grow while the interest you are charged compounds. That is, it gets added to the interest you already owe which you then pay more interest on.
Yes, that’s actually how it works.
I don’t know about you but I was shocked when I first found this out. What the heck I thought.
It just didn’t seem fair. Especially when interest rates are at historic lows.
After all, while the bank is charging you upwards of 25% a year compounded daily on your outstanding credit card balance, it’s only paying you .05% on your hard-earned savings.
Yes, that’s right. A half of one percent. So the interest rate spread, or the difference, on what you’re paying for short term credit and what the bank is paying you is 24.5%
In simple terms, you pay $1,250 and the bank pays you less than $25. And to add insult to injury, they are probably compounding the interest on your debt daily while they compound the interest on your savings monthly.
That means you’re paying $1,225 a year for the privilege of holding a monthly balance on your credit cards.
This interest rate spread is a main driver of banks’ profitability. Which as you may have heard, soared in 2021. Yes, that’s right. Banks had a record busting year last year with profits in the first three months of 2021 up almost 30%.
Wow. That bite looks even bigger now.
But before you get mad and start bashing banks and credit cards, think about all of the amazing services they provide: Loans, mortgages, a safe government insured place to keep your money, overdraft protections and plastic cards that provide points and rewards, the safety and convenience of not having to carry cash around, an ability to get cash advances, the opportunity to build a credit score which helps in obtaining the lowest cost loans, and letting you off the hook for purchases made if your card gets lost or stolen along with protection against merchants for products that may be defective or fraudulent. So it’s not like they’re Doctor Evil or anything, even though sometimes it might seem like it.
Instead of getting mad, why not make a plan to get even?
What’s the best way to get rid of credit card debt?
One website recommends a balance transfer, consolidation of expensive credit card debt with a lower interest personal loan or even having a garage sale or selling your stuff on ebay to raise cash and pay down debt. Or, you can get yet another job or side hustle to make more money.
Only the first of these really offers a solution if you’re as time pressed as most people are. And then, only if you’re going to pay attention and pay down the entire debt or switch credit cards again once the introductory low rate of your chosen balance transfer credit card ends.
If you’re already struggling with debt, obtaining a personal loan on good terms might be difficult. And, it doesn’t remove your debt, it only take if off of your cards which might lead you to start building up monthly balances again if you’re monthly expenses regularly exceed your income.
Sure, having a garage sale or selling extra stuff you don’t need on Ebay is always a great idea to declutter your house and keep things simple (a big fan of Marie Kondo I am not however.) But it’s also a lot of work and again, unless you change the fundamental structure of your monthly cash flows (your incomings versus your outgoings) it’s only a band aid, not a long-term solution.
And if you’re like most working Americans, you probably already have at least one job, if not two and if you’re a working parent, I’m not sure where you’d find the time for yet another job, side hustle or not.
So what IS a good solution?
Do you know how much you actually spend each month on groceries, gas, fast food and clothing? Do you know how many subscriptions you have and how much they cost you each month? Do you know on average how much the gap is between your incoming cash and your outgoing cash?
Of course, you can look it up on all of your various accounts and keep an excel spreadsheet or even a running tally on a piece of paper or in a notebook. But do you really have time for this?
The number one first and most important step in putting your finances on a solid foundation is using a budgeting app. These apps are free and allow you to consolidate all of your accounts in one place. But the biggest advantage is the automated analytical tools that they have that will create graphs and charts of all of your income and expenses and allow you to set monthly budgets.
One principle of successful businesses is Measure What You Do.
The first step in solving a problem is quantifying it.
When you realize how much it is costing you to carry that credit card balance, it serves as a strong motivation to start actively managing your household business so that you can widen the gap between your incomings and your outgoings, in favor of the income side, not the expense side.
Think of your savings as your favorite cause or team. Not some annoying thing that people keep lecturing you on improving. You want your team to win right?
Every time your savings loses, guess who wins? Your bank or credit card company. Do you really want to help them that much?
Many of their services are free of charge, subsidized by that big interest rate spread I mentioned earlier.
But what about those unexpected expenses? Making and keeping a monthly budget is the best way to build up an emergency fund to cover them, or at least pay them down more quickly if you really do need to borrow or carry a monthly balance. Make it as short term as possible.
Here’s a sobering fact:
The S&P 500 which is a stock market index made up of 500 large US companies.
It rose almost 27% percent last year.
That’s how the wealthy get wealthier. They own assets. Like the stock market. When the value of those assets rise, so does their net worth. Even though they might be sitting on the beach doing nothing.
So that $1,250 in interest that you paid your credit card company? Could have made you more than $300 had you invested it in the S&P 500.
Instead of being $1250 in the negative, you’d have more than $1,500 in the bank instead of negative $1250.
What’s the best way to invest in the S&P 500? Buy an index fund. I’ll write more on that later so stay tuned.
So start measuring what you do. Use a budgeting app to get control of your income and expenses.
Then you have your cake and eat it too. Or pie as the case may be.