2.2 Credit Cards

Credit card basics^[1]

A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder’s promise to the card issuer to pay them for the amounts plus the other agreed charges.^[1] The card issuer (usually a bank) creates a revolving account and grants a line of credit to the cardholder, from which the cardholder can borrow money for payment to a merchant or as a cash advance.

Money Coach: Credit Cards 101 (all rights reserved)

Minimum Monthly Payment

The cardholder must pay a defined minimum portion of the amount owed by a due date, or may choose to pay a higher amount. The credit issuer charges interest on the unpaid balance if the billed amount is not paid in full (typically at a much higher rate than most other forms of debt). In addition, if the cardholder fails to make at least the minimum payment by the due date, the issuer may impose a late fee or other penalties. To help mitigate this, some financial institutions can arrange for automatic payments to be deducted from the cardholder’s bank account, thus avoiding such penalties altogether, as long as the cardholder has sufficient funds.

Grace Period

A credit card’s grace period is the time the cardholder has to pay the balance before interest is assessed on the outstanding balance. Grace periods may vary, but usually range from 20 to 55 days depending on the type of credit card and the issuing bank. Some policies allow for reinstatement after certain conditions are met.

Usually, if a cardholder is late paying the balance, finance charges will be calculated and the grace period does not apply. Finance charges incurred depend on the grace period and balance; with most credit cards there is no grace period if there is any outstanding balance from the previous billing cycle or statement (i.e. interest is applied on both the previous balance and new transactions). However, there are some credit cards that will only apply finance charge on the previous or old balance, excluding new transactions.

Interest Payments

Credit card issuers usually waive interest charges if the balance is paid in full each month, but typically will charge full interest on the entire outstanding balance from the date of each purchase if the total balance is not paid.

For example, if a user had a $1,000 transaction and repaid it in full within this grace period, there would be no interest charged. If, however, even $1.00 of the total amount remained unpaid, interest would be charged on the $1,000 from the date of purchase until the payment is received. The precise manner in which interest is charged is usually detailed in a cardholder agreement which may be summarized on the back of the monthly statement.

Financial institutions refer to interest charged back to the original time of the transaction and up to the time a payment was made, if not in full, as a residual retail finance charge (RRFC). Thus after an amount has revolved and a payment has been made, the user of the card will still receive interest charges on their statement after paying the next statement in full (in fact the statement may only have a charge for interest that collected up until the date the full balance was paid, i.e. when the balance stopped revolving).

The credit card may simply serve as a form of revolving credit, or it may become a complicated financial instrument with multiple balance segments each at a different interest rate, possibly with a single umbrella credit limit, or with separate credit limits applicable to the various balance segments. Usually this compartmentalization is the result of special incentive offers from the issuing bank, to encourage balance transfers from cards of other issuers. In the event that several interest rates apply to various balance segments, payment allocation is generally at the discretion of the issuing bank, and payments will therefore usually be allocated towards the lowest rate balances until paid in full before any money is paid towards higher rate balances. Interest rates can vary considerably from card to card, and the interest rate on a particular card may jump dramatically if the card user is late with a payment on that card or any other credit instrument, or even if the issuing bank decides to raise its revenue.

Fraud Protection

Some countries, such as the United States, the United Kingdom, and France, limit the amount for which a consumer can be held liable in the event of fraudulent transactions with a lost or stolen credit card.

Money Coach: Credit Cards – Mistakes and Best Practices (all rights reserved)

Credit card calculations

Average Daily Balance^[2]

Credit card companies do not charge you interest on your ending balance. Instead, they charge you interest on your “average daily balance” or ADB. Essentially, this is the average debt you had during the month on a daily basis.

Khan Academy: APR and Effective APR

To help understand the process, let us consider an example.

Suppose that your credit card statement dates run from the 1st of the month until the last day of the month. In reality, statement periods can run between any dates, but things will be less complicated if we think of one complete month.

Below is a table that shows your activity for the month:

To calculate the ADB, we need the following information: Balance, Days at Balance, and Balance x Days at Balance. So let us work through the example above. Remember: our statement period runs from January 1 – January 31. (There are 31 days in January).

• From Jan 1 – Jan 8 (8 days), you had a balance of $600.
• From Jan 9 – Jan 14 (6 days), you had a balance of $700.
• From Jan 15 – Jan 23 (9 days), you had a balance of $1,000.
• From Jan 24 – Jan 30 (7 days), you had a balance of $600.
• From Jan 31 – Jan 31 ( 1 day), you had a balance of $2,100.

Quick tip: Never be worried about counting days on your fingers…that’s what I do! And count the number of days to make sure it adds up to the number of days in the month (to be sure you did not double count.)

We can now create the following table:

Then, the ADB is calculated as (Balance x Days)/Days. For this problem, we get $24,300/31=$783.87.

Before we take a look at the interest charged, it should be noted that a large purchase was made at the end of the month. This purchase will have a minimal impact on the ADB because it was only part of the balance for one day. However, this will have a large impact on the next month assuming that the card is not paid.

Next, we will calculate interest. This is relatively straight forward (at least compared to the compounding interest problems.) This will be done in four steps.

1. Calculate the ADB.
2. Take the interest rate (APR) and divide it by 365.
3. Multiply the result by the ADB.
4. Multiply the result by the number of days in the month.

So for our problem, we saw an ADB of $783.87. Further, let us us suppose that the interest rate (APR) on the card is 21.99%. So following the steps laid out above:

1. ADB = $783.87.
2. .2199/365=0.000602
3. ($783.87)(0.000602)=$0.472
4. ($0.472)(31)=$14.63

Khan Academy: How Credit Card Interests are Calculated (CC BY)

The final calculation we need to look at is the monthly payment. There is no standard rule for this as it varies from one credit card to the next. So let us use the following rule for this class:

1. If the balance is $35 or less, the minimum payment is the entire balance.
2. The minimum payment is the larger of a) $35 or b) 2% of the balance + interest.

So for our example, 2% of the balance is (0.02)(2,100)=42 plus the interest of $14.63 gives a minimum monthly payment of $56.63. Note that while the large purchase at the end of the month did not affect the ADB much, it does affect the minimum payment since we take 2% of the ending balance and not the ADB.

Note: The calculation we just did is technically incorrect. Generally, you have one statement to pay off your credit card before interest is charged. So if you were to pay off her credit card during the next month (February), there would be no interest on your January purchases. We will not add this complication to our problems!

Credit card usage tips^[3]

Disclaimer: These are things I believe and things I feel work. This may not work for anyone, so use any tips from me with caution.

1. Never use a debit card…always use a credit card…if you can do so responsibly!
2. Pay your balance each month.
3. It is okay to have multiple credit cards…especially if they are reward-specific.
4. Be sure to use cards once every six months.
5. If you are considering a large purchase, shop for credit cards. They will typically offer 6-18 months of no interest. Again, responsibility is key!
6. Watch for annual fees. Many cards are free, but others do charge an annual fee. This is sometimes worth it, especially for travelers, but not generally worth it for college students/younger people.

The Danger of the Monthly Minimum

Note: I will not show any math here. Rather, I will just illustrate an example.

Suppose you want a new PS5. But you also need a 4k television. So you decide to use a credit card to buy everything and figure you will just make monthly payments. Let us assume that the cost of everything is $2,000. Also, let us assume you put it on a credit card where your interest rate is 23.99%.

The first issue is that credit card utilization is part of your credit score and college students generally have lower credit limit. So you may only have a total of $5,000 of credit available (and that is probably high), so you are using 40% or more of your credit limit. This could drop you credit score by 50+ points which could have a cascading effect on your ability to buy a car, get a job, rent an apartment, etc.

But the second issue is the time it takes to pay down the debt. Using this calculator from bankrate.com, I find that if you just pay the minimum on your card each month assuming that is your only purchase and you make no other purchases, then it will take you 193 months (more than 16 years) to pay off your credit card and you will pay a total of $5,328.11. This means that you will pay $3,328.11 in interest! Now realistically, as your income increases, you would be able to pay this off faster, but other bills will likely start as you get older as well. It is best to avoid having baggage like this!

Payday Loans

This will be quick, but important. Avoid payday loans. I will illustrate why below, but avoid them. They can create an unbreakable cycle of debt. But in the event you need  a payday loan, you need to understand how they work.

A payday loan^[4] (also called a payday advance, salary loan, payroll loan, small dollar loan, short term, or cash advance loan) is a short-term unsecured loan, often characterized by high interest rates.

The term “payday” in payday loan refers to when a borrower writes a postdated check to the lender for the payday salary, but receives part of that payday sum in immediate cash from the lender.^[1] However, in common parlance, the concept also applies regardless of whether repayment of loans is linked to a borrower’s payday.^[2][3][4] The loans are also sometimes referred to as “cash advances,” though that term can also refer to cash provided against a prearranged line of credit such as a credit card. Legislation regarding payday loans varies widely between different countries, and in federal systems, between different states or provinces.

To prevent usury (unreasonable and excessive rates of interest), some jurisdictions limit the annual percentage rate (APR) that any lender, including payday lenders, can charge. Some jurisdictions outlaw payday lending entirely, and some have very few restrictions on payday lenders.

Payday loans have been linked to higher default rates.^[5][6][7][8]

The basic loan process involves a lender providing a short-term unsecured loan to be repaid at the borrower’s next payday. Typically, some verification of employment or income is involved (via pay stubs and bank statements), although according to one source, some payday lenders do not verify income or run credit checks.^[9] Individual companies and franchises have their own underwriting criteria.

In the traditional retail model, borrowers visit a payday lending store and secure a small cash loan, with payment due in full at the borrower’s next paycheck. The borrower writes a postdated check to the lender in the full amount of the loan plus fees. On the maturity date, the borrower is expected to return to the store to repay the loan in person. If the borrower does not repay the loan in person, the lender may redeem the check. If the account is short on funds to cover the check, the borrower may now face a bounced check fee from their bank in addition to the costs of the loan, and the loan may incur additional fees or an increased interest rate (or both) as a result of the failure to pay.

In the more recent innovation of online payday loans, consumers complete the loan application online (or in some instances via fax, especially where documentation is required). The funds are then transferred by direct deposit to the borrower’s account, and the loan repayment and/or the finance charge is electronically withdrawn on the borrower’s next payday.

I will not go over it here, but Wikipedia has an interesting argument in favor of payday lending which can be read about halfway down the page here (Proponents’ stance and counterarguments).

PBS: Fighting the Debt Trap of Triple-Digit Payday Loans

Calculations

Payday loans, as mentioned, are very short-term. So let us imagine that we need a $500 loan until our next paycheck which is in 8 days. Using CashNetUSA for Alabama (the site does not offer loans in Pennsylvania). They charge $17.50 per $100 borrowed. If you absolutely need the $500, then paying $87.50 for the money may be worth it. But it is also extremely expensive. Let us use a simple interest calculation to determine the interest rate. (Note: We did not do simple interest in this class and I will not ask you to do it, but I do want to illustrate the interest rate). When we calculate interest, we find it using the formula I=PRT where I is the interest charged, P is the amount borrowed, R is the interest rate, and T is number of years. So in our case, I is the money we are paying, which is $87.50, P is the money borrowed, which is $500, and T is the number of years. But since we only have a 10 day loan, then the number of years is 10/365.

We want to solve for I, so dividing both sides by PT, we get R=I/(PT)=87.50/((500)(10/365))=6.39. Now you may look at that and say 6.89% isn’t bad at all. But remember that is a decimal. In other problems we would have gotten a value like 0.06 for 6%. So 6.39 is NOT 6.39%…it is 639%!

The issue with payday loans is that people are often unable to pay off the loan, so they have to renew the loan…and in most cases for more as the interest will be added to the loan. This is why maintaining good credit is so important. If you need a short-term loan and have credit cards with ample credit available, you can always use a cash advance. While these are still expensive, they are far superior to payday advances. A typical credit card will charge you a 5% or so fee and around a 25% interest rate. They can also be paid over time just as any other credit card debt would be. Again, I do not advocate using cash advances, but having available credit can save you tons of money.