Credit cards are a terrific convenience but also can be very costly. Effective use of a credit card can make life easier and improve your credit score. On the other hand, credit cards are an example of bad debt. It is easy to buy more than you can afford using a credit card, leading to high interest charges and a lower credit score. The latter process can lead to a downward spiral as the purchases you couldn’t afford lead to ever increasing finance and interest charges on your credit card. At the same time, your credit score goes down which increases the interest rate on other loans, if you can get them at all as discussed in this post. For a real-world example of how credit cards and lead to a financial disaster, check out this post about a friend of mine.

In this post, I’ll explain how credit cards work, including how finance and interest charges normally apply. Every credit card is different, so you’ll want to look closely at the terms of any credit cards you currently carry or for which you plan to apply.

How They Work

When a financial institution issues you a credit card, it is offering you a loan in an amount that you can choose based on the amount of your purchases up to your credit limit.

Credit Cards from Your Perspective

From your perspective, you:

Pay the annual fee, if there is one.
Make purchases or get a cash advance. When you get a cash advance, you are borrowing cash from your credit card company instead of borrowing money to buy something. You can get a cash advance at an ATM, among other places.
Pay your bill – hopefully the full amount every month, but at least the minimum payment if at all possible. If you don’t pay your bill in full, issuers will add interest charges to your next bill, as discussed below. If you don’t pay as much as your minimum payment, they will also add finance charges.
Get rewards. Many credit cards provide rewards in the form of cash back or “points” that can be used for travel or other purchases.

In addition, you have the option to transfer your balance from one credit card to another. Many people make this type of transfer when they have at least one credit card with a very high interest rate and one with a low interest rate. By transferring the balance from the high-rate card to the low-rate card, you can reduce the amount of interest you will pay. Most issuers charge a fee of roughly 3% of the amount transferred when you make a transfer. If your interest rate decreases by more than 3 percentage points and you are paying off your credit card debt fairly slowly, though, your interest savings will be more in one year or a little longer than the transfer fee. As discussed below, though, the transfer could impact the interest charged on other purchases, so you’ll want to look at the whole picture before making a transfer.

Credit Cards from the Issuer’s Perspective

Income

The credit card issuer generates revenue from several sources:

Your annual fees.
Interest and financial charges you pay.
Fees it receives from vendors who accept their credit cards. Most issuers require vendors to pay them 2% to 4% of the amount of your purchases. Recently, some vendors have started passing these fees on to customers. That is, they charge customers who use credit cards more than customers who use a check or pay cash. I ran into that when paying for many of the costs of our daughter’s wedding. To keep the cost down, I made sure I paid any vendors who charged these fees using an electronic transfer.
Finance charges. If you don’t make a payment toward your credit card bill at all or the amount you pay is less than the minimum payment, issuers charge you a fee in addition to the interest charges.
Cash advance fees. Many issuers charge $10 to $25 or 5% of the amount every time you get a cash advance. I never use my credit card for a cash advance as 5% of the cash is a steep charge to access cash. There are emergencies, though, when having cash at any price is imperative.
Foreign transaction fees. Many issuers charge fees when you buy something outside your home country. I carry two Visa cards one of which charges me 3% on my purchases every time I leave the US. For years, I carried only one credit card but I was leaving the US for a month to travel and decided I wanted a back-up card. I went to the bank where I keep my checking account and clearly didn’t read the fine print! In hindsight, it was silly to get a back-up credit card for travel with such a high foreign transaction fee.

Issuers' Expenses

Credit card issuers have four primary expenses – their overhead costs (salaries, rent, etc.), the cost of the rewards they give customers, the cost of borrowing the money that they “loan” you between the time you make a charge and pay your bill, and the amount of money they have to write off because customers don’t pay their bills.

When Do You Pay Interest

If you pay your credit card bill in full every month, you don’t transfer a balance from another card and you don’t get a cash advance from your credit card, you won’t pay any interest. When you do any of those things, you’ll get interest charges.

Interest on Unpaid Balances

You pay interest on unpaid balances from the day they are due until the day the issuer receives your payment for those charges. Once you haven’t paid your previous bill in full by its due date, though, the issuer starts charging interest on the day you make each future purchase rather than starting on the day the bill is due until all charges have been paid in full. I’ll provide an example of this difference below.

Interest on Cash Advances

You pay interest on cash advances from the day you withdraw the money until the day the credit card company receives your payment. I looked at one of my credit cards and it has a higher interest rate on cash advances in addition to having interest charges from the date of the withdrawal. The same is true with other credit cards I’ve seen on line or discussed with my friends.

Interest on Balance Transfers

Some issuers allow you to transfer the balance from one credit card to another. You might want to do this type of transfer if the interest rate on one card with a balance is significantly higher than another card you hold. When you make this type of transfer, the issuer starts charging you interest on the day of the transfer and continues to do so until you pay the balance in full.

In addition, even if you had previously paid off the balance on the card to which you transferred your balance, you will pay interest on all new purchases starting on the date of purchase. That is, until you have fully paid off your credit card balance including the amount transferred, you do not get a grace period between the date of purchase and the due date of your bill. The additional interest could offset some or all of the savings you attain by reducing your interest rate when you transfer a balance. This article from creditcards.com provides more details about some of the risks and benefits of transferring a balance.

How Is Interest Calculated

Still confused about how and when interest is calculated? Hopefully these examples will help. Before going into the examples, I need to explain what the interest rate or APR (annual percentage rate) really means.

A 24% APR, for example, doesn’t mean you pay 24% interest if you carry your balance for a full year. The 24% is divided by 365 (number of days in a year) to get a daily rate. The daily rate is multiplied by your balance on each day and added to the balance for the next day. As such, if you didn’t pay or charge anything on your balance for a year, the interest rate on the beginning balance would not be 24%, but rather 27.1%! I calculated 27.1% as

(1+.24/365)365 – 1.

By raising the term inside the parentheses to the 365 power, I’m compounding the daily interest charge for a full year (365 days).

Example 1 – Paid Bill in Full Last Month

In the first example, I’ll show how interest is calculated if you paid your bill in full at the end of the previous billing cycle. Here are the assumptions for this example:

Interest rate on charges = 18%
Cash advance interest rate = 24%
The cash advance fee is the greater of $10 or 5% of the amount of the cash advance
You make a $500 purchase on Day 5
You take a $100 cash advance on Day 8
Your issuers receives your payment on Day 10 of the next billing cycle (i.e., 33 days after you took the cash advance)

In this example, you don’t pay any interest on the $500 purchase during this billing cycle.The cash advance is different. First, you are charged the cash advance fee. 5% of your cash advance is $5 which is less than the $10 minimum, so you will be charged $10 as a cash advance fee. In addition, you will pay interest at a 24% APR. The interest charge is $2.19 which is calculated as:

As such, you will re-pay the issuer $112.19 for the $100 cash advance you received. This example illustrates why it is often better to tap sources of cash other than your credit card, if at all possible.

Example 2 – Didn’t Pay Bill in Full Last Month

In this example, I’ll show how interest is calculated if you didn’t pay your bill in full at the end of the previous billing cycle. Here are the assumptions for this example:

Interest rate on charges = 18%
Unpaid balance from last month = $750
You make a $500 purchase on Day 5
Your issuer receives your payment in full on Day 10 of the next billing cycle

I haven’t included a cash advance in this example because it will cost you the same amount regardless of whether you paid your bill in full in the previous month.In this example, you will pay interest on your unpaid balance for the 30 days in the month plus the 10 days into the next billing cycle, for a total of 40 days. The interest on this balance totals $14.93 and is calculated as:

In addition, you pay interest on the $500 purchase for 25 days in this billing cycle plus the 10 days in the next billing cycle, for a total of 35 days. The interest charge on this purchase is $8.70 for a total interest charge of $23.63. If you have gotten behind on your credit card balances, check on this post for strategies that will help you get caught up.

The Best Credit Card for You

As with every financial decision, picking the best credit card for you requires balancing the costs and benefits. In large part, the best credit card for you depends on how you will use it. The bottom line is that you want the credit card that will have the greatest net benefit or lowest net cost for you. Here’s how you can calculate that benefit/cost.

Pluses

The plus in the equation that determines your net benefit is the value of any rewards you earn. Some credit cards provide no rewards, so the total plusses equal 0. Other credit cards provide rewards, such as 1% of all purchases or 5% of gas purchases plus 3% of food purchases plus 1% of everything else.

To calculate the value of the benefits, you’ll need to estimate how much you expect to charge on your credit for each category of expense. You can then multiply those benefits by the corresponding reward percentage. As an illustration, I’ll use the 5% for gas, 3% for food and 1% of everything else example I mentioned above. The table below shows three different combinations of monthly expenses in those categories and the rewards you would earn.

By comparison, you would receive $10 a month or $120 a year with a credit card that provides 1% back on every purchase under all 3 scenarios. I note that most credit cards do not give rewards for cash advances, so I have not included them in the table above.

Some rewards are harder than others to access or might be in a form that isn’t useful for you. If that is the case with one of the credit cards you are considering, you might reduce the annual benefit by some amount, such as 50%, for the chance that you don’t use it.

Minuses

Offsetting the rewards are all of the fees and charges I mentioned above – the annual fee, cash advance fees, finance fees, foreign exchange fees and interest charges.The table below shows the fees I’ve used for illustration for the two cards above.

To keep the examples simpler, I’ve assumed you make at least the minimum payment every month so there are no finance charges and you have no foreign transactions.

Example 1

In the first example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment. You pay your bill in full every month.In this example, your annual costs are $243 using the higher reward card and $150 using the lower reward card. The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards, remembering that the lower-reward card has the same rewards under all three scenarios. A negative net cost means that you pay more in fees than you get in rewards, whereas a positive net cost means you get more in rewards than you pay in fees.

In this example, you don’t incur many fees, so the lower fees in the lower-reward credit card don’t help you. As such, you are better off with the higher-reward credit card under all three spending scenarios.

Example 2

In the second example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment. Unfortunately, you got behind on your credit card payments so you average 60 days between the time you make each purchase and take out your cash advance and pay your bill.

Your annual costs are $652 using the higher reward card and $379 using the lower reward card. The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards.

In this example, the lower-rewards credit card has a lower net cost than the higher-rewards card, unless you buy a lot of gas in which case you are somewhat better off using the higher-rewards card.

Summary

This comparison illustrates that high-rewards credit cards are not always the best. To select the best credit card, you’ll want to balance the fees you are likely to pay based on your spending and payment patterns with the available rewards and their usefulness to you.

Jul 30 Credit Cards: What You Need to Know