Last night I overheard an interesting conversation about how credit cards work.
I have heard too many stories like this. Smart people — competent people — who don’t understand the basics of how credit cards work.
So how do credit cards work?
I cannot stress this enough. You must, must, must pay at least the minimum payment each month. If you don’t your credit rating will be damaged and, after a certain amount of time, your credit card company can sell your bill to a collections agency — who will then hound you day in and day out, until you pay.
Fortunately, minimum payments are often very small amounts because the credit card companies understand that by offering you a chance to make such a small payment, they are able to charge you a ton of interest on the entire balance (little known fact: If you charge $100 to a credit card and pay $99, you will be charged interest on $100, not $1).
How Interest Charges Work
Let’s pretend that, on January 30th, when my credit card bill was due, I didn’t have enough money to pay my rent and my bill. If I paid the minimum payment of $10, on my next credit card statement I would see a whopping $25.95 in interest. And my minimum payment would increase to $35.95 (minimum payment of $10 + accrued interest).
Guess how long it would take me to pay off my credit card at an interest rate of 19.99%?
Canadian and American banks are now required to include a mention, on your statement, of how long it would take you to pay off your balance if you only paid the minimum payment. In my case, it would be almost 14 years — and that’s if I didn’t charge anything else to my credit card in the meantime.
How Credit Cards Work Psychologically
Psychologically, credit card balances that hang over you for years can lead to stress, shame and guilt. I will be writing a post soon on how to motivate yourself into paying off you credit card.
Credit cards are fantastic tools and are often required in modern society. However, a laissez-faire attitude towards debt, and a lack of financial literacy has led to a society in which consumers are often unaware of the financial tools that they are using. Share this post to help educate others about how credit cards work.