At work the other day, I overheard a conversation about credit cards. I literally was pulling my hair out and wanted to jump in and go all YoungMoney Finance on them. “Well you don’t have to pay it off every month” and “you have this many days to make a payment” and “just pay the minimum.” Gaa! It was at this point that I realized I needed to do a post explaining how credit cards work. Swipe away!

How did we come up with credit cards?
Credit cards started as a manner of convenience for customers. Instead of paying every time you went to the store, the shopkeeper would just keep a record of your purchases and you would settle up at month’s end. It then morphed into a system whereby you kept a ‘running tab’ with your credit card bank and would spend money and then pay them back (either in full or slowly). The concept was well received by a population that wanted something now but couldn’t necessarily pay it in full. Credit cards let them get what they wanted now and pay for it slowly over time.

How does the credit card cycle work?
You typically have one month, or 30-31 days in your billing period. All the purchases you make during that time frame are accumulated and you get your statement a couple of days after the close. Once you get your statement, you have until the ‘payment due’ date to pay your bill in full or you’ll be charged ‘interest’ on your outstanding balance, until you pay it all off. There is a difference between paying your bill to avoid interest and the minimum payment. The minimum payment (depends on your card, mine are $25 or $35) is the very least you have to pay. If you miss a payment you’ll be charged a late payment fee on top of your interest that you’ll already owe, and it’ll reflect quite negatively on your credit score. Missing a payment will also cause a big jump in the interest rate you pay (could be an increase of 10 basis points, i.e. from 15% APR to 25%). Paying at least the minimum balance will still hit you with interest on the remaining balance, but not a late payment fee. It’s best practice to pay off your credit card balance each month in full so you don’t pay any interest, but if you can’t do that you absolutely should pay the minimum payment.

How does the interest calculation work?
Credit card companies try to make it as confusing as possible, probably to keep us as consumers in the dark and to make as much money off us as they can. I looked at two of my credit cards and they both use the Average Daily Balance method to compute interest, so I’ll explain the interest that way. It all starts with the APR (Annual Percentage Rate, which can be close to 0% or as high as 30+%. That’s the interest rate that the company uses. Then, the credit card company takes the average daily balance of your account. That’ll be any outstanding balance – anything you haven’t paid off yet – plus any new transactions, then minus any payments you may have made. This number is summed up for the month and divided by the number of days in the period (usually 30 or 31). Your APR is then divided by 365 (to get a daily rate) and multiplied by the cumulative balance for each day. Your balance is compounded by interest, which sort of sucks for you. It means that, for example, if you were charged $10 of interest that month on a balance of $100, your new balance is $110 and they’ll include that amount in your daily balance. The cycle goes on and on.

Credit cards, when properly managed, can be a great tool for you to budget, keep track of your expenses and earn rewards. I’ve earned several hundred dollars in free travel over the past two years. On the other hand, credit cards can quickly get out of control if you let them and become terrible little plastic cards of pain and suffering. With great power comes great responsibility.

Mo’ Money, Mo’ problems. YoungMoney, no problems. Follow us on Twitter.

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