The True Cost of Credit Card Debt

Credit cards are important financial tools that can make purchases more convenient as they help you build credit and earn rewards. However, carrying credit card debt from month to month can come at a significant cost.

In fact, Americans paid more than $120 billion in credit card interest and fees annually from 2018 to 2020, according to a Consumer Financial Protection Bureau (CFPB) study. The true cost of carrying credit card debt depends on several factors. Learn what affects credit card debt’s expense and what you can do to reduce or eliminate it.

How To Calculate Credit Card Interest Costs

For most people, the interest that credit card companies charge is the largest, and sometimes the only, cost of using a credit card. Credit card companies usually calculate how much to charge you each month by using the average daily balance method. Credit card companies might not list your daily balance changes on your statement.

Let's walk through how this calculation works with an example, using credit card debt of $5,000, which is about the average balance a U.S. cardholder carried in 2020, according to the Consumer Financial Protection Bureau (CFPB). This example assumes you carried a balance of $4,000 through the 15th of the month, at which point you made a single $1,000 charge.

The step-by-step calculation goes like this:

1. Add up your balance for each day for the month.

   ($4,000 x 15 days) + ($5,000 x 15 days) = $135,000

2. Divide the total balance by the number of days in the month. This will tell you what your average balance was for each day.

   $135,000 / 30 = $4,500

3. Calculate the daily periodic rate. This is how much interest you'll pay each day, expressed as a percentage. It's simply your credit card interest rate divided by 365. For example, if your card charges a 17% APR, your daily period rate would be 0.00047 (0.17 / 365)

4. Calculate the daily interest owed. Now you can calculate how much interest you owe for any given day. Multiply your daily periodic rate by the average balance.

   $4,500 x 0.00047 = $2.12

5. Calculate the monthly interest owed. To see how much interest you'd owe in a month, multiply how much interest you're paying every day by the number of days in the billing cycle. This is your interest charge for the month.

   $2.12 x 30 = $63.60

This example is just a summary of how to estimate your actual interest charges.

Compounding Interest Costs Can Add Up Quickly

Most credit card companies use "compounding" when calculating your interest charges, which results in a more expensive monthly charge.

For example, say you have a daily interest owed of $2.12 for each day of the month using the basic average daily balance method with compounding. Instead of charging $2.12 for each day of that month, credit card companies will start with that number for the first day, and tack it onto your balance for the next day. So on the second day, your balance is actually $2.12 higher, which increases the average daily balance and, ultimately, how much total interest you pay that day.

Compounding interest means that your debt increases significantly faster because each day you're paying interest on the interest from the previous day. The higher your interest rate and the higher your balance, the faster your debt will increase.

Other Credit Card Costs and Fees

Depending on the terms of your credit card, you may have to pay other fees. Check your card's terms and conditions brochure to see what changes apply to you:

• Annual fee: Some cards charge a fee each year on your cardholder anniversary.
• Other types of interest: Many credit cards charge a different interest rate if you use it for a cash advance. Charges with other interest amounts are tracked and calculated separately from normal purchases.
• Late fees: You may be charged a fee if you make a late payment. The exact amount and when it applies may vary by credit card.
• Returned payment fees: If you make a payment and it's returned by the bank, you may incur a fee.
• Foreign transaction fees: Some cards charge extra if you use your card to make a purchase in a different currency.
• Balance transfer fee: If you transfer a balance from another credit card, you might have to pay a percentage of the transfer amount.

Tackling Credit Card Debt and Controlling Costs

On average, people with credit card debt paid $1,000 each year from 2018 to 2020 in fees and interest, according to the CFPB. The median household income was about $65,000 during that time period, which means cardholders spent about 1.5% of their earnings on credit card fees.

Here's how you can reduce the cost of credit card debt:

• Pay your bill in full every month: If you pay your bill in full each month, you can avoid paying any interest charges.
• Choose a debt payment method: Figure out whether the debt snowball or debt avalanche payoff method would be better for you. With the debt snowball method, you pay off cards with the lowest balance first. With the debt avalanche method, you pay off the credit cards with the highest interest rates first.
• Refinance your debt to a lower rate: Paying a lower rate on your debt means that more money each month goes toward paying down the balance, rather than interest charges to your lender.
• Try a 0% balance transfer card: Similar to refinancing for a lower rate, some credit cards have an introductory balance transfer offer for a certain number of months with no interest. That can help you reduce your debt faster—but be aware of the risks. Consider the balance transfer fees and whether you can pay it all off before the end of the introductory period.
• Get in the habit of budgeting: Creating a budget and sticking with it can help you reign in your spending so you have more money to pay down credit card debt and save on interest charges.
• Increase your income: You can only cut so much from your budget. But if you're able to boost the other side of the coin—how much money you earn—you'll be able to make quicker progress in paying off your debt.
• Use financial advisors or professionals: If you're struggling with credit card debt, try getting a referral for professional guidance from the National Foundation for Credit Counseling. A reputable credit counselor can work with you toward a solution that fits your situation.

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