How Credit Card Interest Really Works

Despite the Credit Card Act of 2009 , the credit card industry is the only one that still has the right to change the terms of a contract after it has been signed. Many consumers sign up for a credit card when the interest rate is low, such as 7.9% per year. Then they miss a payment or are even just a few days late on a payment and the credit card issuer raises the rate. The new increased rate now applies for the entire unpaid balance on the card, even though the balance was charged when the old rate was in effect. It is this terrible cycle that keeps consumers in debt forever, because they end up paying interest on interest. Often, items that are carelessly charged on a credit card are paid several times over because of interest.

Here’s an example of how interest gets charged on interest:

1. Consumer charges $50 on a new credit card with the low introductory rate of 7.9%.
2. Anytime between a few days and a few weeks later (depending on the billing cycle) consumer receives a credit card statement for $50 (assuming no other charges have been made).
3. If whole balance is paid in full, no interest is charged.
4. If consumer pays $20 toward balance, a little more then the minimum, the next month’s balance will be $30.20. This doesn’t seem bad, just the $30 owed on the $50 purchase plus 20¢ interest.
5. The following month, the consumer is charged interest on the balance due, $30.20. After a few months of charging and paying minimum payments, consumer is paying interest that is compounded monthly (actually it is calculated on the daily average that the consumer owes, so it adds up even faster.)

After a year, a credit card balance of $100 will be more than $110 at 7.9% but more that $122 at 19.9%. And a balance of $8000 (the average credit card debt owed by a US family) will be $8655 at 7.9% but $9745 at 19.9%. And that doesn’t count the late fees for non-payment and the interest on those fees.

Think your finances through the next time before you whip out the plastic at the mall. If you don’t have the cash to pay off the balance immediately, you may end up paying off that pair of shoes from the clearance rack for a very long time.