Today’s post comes to use from Kathryn, a dedicated My Personal Finance Journey reader and a valuable contributor to the commentary on a lot of posts during the past 6 months. Enjoy as she shares her story of how she got out of credit card debt.
A Credit Card Saga – And How I Survived
The company I work for is sending me to England on a 6 month assignment. Because of this, I called the bank to ask them to place a note on my account that says that I am living in England.
As part of this conversation, the banker informed me that I was pre-approved for a Wells Fargo credit card. While it would be nice to have a credit card while overseas, I had to respectfully decline this particular card on principle. The rate, following the introductary APR of 0% for 12 months, skyrockets to a variable 17.5%! Also, if you miss a payment, the variable APR jumps to 27.3%! Wow. That’s a ton of interest.
People often talk about sub-prime mortgages as a major reason for the current economic woes. Little has been discussed about credit cards, which appear to be equally as predatory. To see how this type of credit card could truly bite you, let’s use a situation from my college days:
The Saga Begins – Get Ready
When I was a senior in college, in my last semester, I had a job lined up and my parents informed me that they would no longer be paying for my living expenses. Without any money secured, I applied for a credit card to use as a stop gap until I started making real income. I would not advise anybody to do this, for the reasons that I will discuss below.
I charged approximately $3000 in living expenses over a 6 month period, and paid the card minimum ($20) each month. The card interest rate was 0% for the first 6 months, and then it jumped to 11 APR%. This particular credit card was compounded monthly.
It is important to note that the rate that the credit card company gives you is not exactly the actual interest rate. A more adequate way of characterizing the actual rate for a stable balance over a year period is call the EAR, or effective annual rate.
Let’s take a moment to explain what EAR is to get everyone on the same page.
- You can convert your APR to an EAR by using the following formula: EAR=((1+APR/n)^n)-1. n represents the number of compounding periods in a year.
- Thus, a credit card with an 11% APR compounded monthly is actually earning interest of around 11.6% per year.
- The Wells Fargo credit card I mentioned above has a 17.5% interest rate, compounded daily. That means the effective annual rate is 19.1%.
So, as you can see, a monthly compounding would be closer to the actual rate than a daily compounding. For the penalty rate of 27.3%, the effective annual rate with daily compounding would be 31.4%. Yikes!
Let’s say that in the first 6 months, I charge $500 per month to my credit card and pay the minimum off. This would mean that at the end of the 6 months (in the introductury period), I have a balance of $2880. Under the credit card I used, if I continued to pay the minimum, and didn’t charge anything else, my balance would continue to increase as follows (note that I am using EAR/12 as an estimate for the monthly interest):
- Month 1: $2880 (1+(0.116/12)) – $20 = 2887.84
- Month 2: 2887.84 (1+(0.116/12)) – $20 = 2895.76
- Month 3: 2903.75
- Month 4: 2911.82
- Month 5: 2919.97
- Month 6: 2928.19
Okay…so now, in 12 months, I have charged $3000, but the total amount I’ve committed to giving the credit card company is $3168.19. And this is assuming I have that much money to pay the credit card company after 12 months, otherwise the balance will continue to increase. Honestly, this credit card isn’t too bad because of monthly compounding and the relatively low APR.
However, let’s do the same scenario under the Wells Fargo credit card with the 17.5% rate and daily compounding. Let’s say I have the same starting balance of when the interest rate kicks in. What does the amount of money I have committed to the credit card company come out to after 6 months? $3375.09. Wow! That’s a $375 profit for the credit card company.
The problem that people get into with credit cards is that they rack up a large balance and then don’t have the means to quickly pay it off. Once the balance gets higher, the interest starts going higher. And then you gain interest on that interest. The other problem is that variable rates can change at any time. Just because your credit card has a 17.5% rate today doesn’t mean it won’t have a 27% rate when your check gets lost in the mail.
As another scenario, say I’m a student who has put up $3000 in credit card debt over several years. What if I have the means to pay off $200 to this credit card per month? Under a normal, no interest situation, it would take me 15 months to pay my credit card off. However, say I pay my $200/month, but at month 6, the check gets lost in the mail. How long would it take to pay off this credit card? 18 months. And I’ve paid over $500 in interest.
What if I only have the means to pay $100 to this credit card per month? No interest, 30 months to pay it off. Under the scenario above, it would take 47 months and almost $1700 in interest. That’s over 50% of what I charged originally!
My Debt Repayment Method and Some Lessons Learned to Pass On
So, there are a few lessons to be learned.
- First, if you have gotten yourself into trouble with credit cards, you need to pay the largest possible amount of money you can pay to that credit card every time. In the scenario above, an extra $100 per month decreased the interest by over $1000 and allowed payoff much quicker. That will reduce the interest that your interest is earning.
- Second, try to find credit cards that compound monthly. Apparently, these are few and far between these days.
- Third, convert your APR to an EAR to get a better feel for how compounding will affect your interest rate. Be careful with how you use credit cards and never spend more than you earn.
How about you all? Do you have any credit card debt stories to share? Have you ever made purchases on a credit card knowing that would were not going to pay it back any time soon?
Please share by commenting below!
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Related articles about credit card debt stories at several of my favorite personal finance blogs: