Professor Erkis, how does interest charged on credit cards work? I paid the minimum monthly payment last month and was then charged interest the following month. Could you explain what is going on please? -Devyne N. ’21 undecided business major.
Erkis: This is an excellent question. The credit card company charges no interest if you pay all of the amount owed on your statement by the due date every month. If you run a balance, they charge interest at high rates like 14% for someone with excellent credit, to 26% for someone with fair credit. This is why it is critical to pay off the balance every month before the due date.
If you do not pay the entire balance due at the end of the month, the credit card company charges you interest on the unpaid balance from the beginning of that first month. It also begins charging you interest on all transactions from the date of the transaction. This “double whammy” of being charged interest on the unpaid balance and on all new transactions dramatically increases the interest owed if you use the credit card frequently.
At that point, the only way to get out of high interest charges is to stop using the card for a few months. To explain why, assume John did not pay his previous month’s balance in full and is being charged interest. John receives his next month’s statement showing a balance of $1,000 with a payment due date of March 9. John pays his entire balance of $1,000 before the March 9 deadline. Thinking everything is OK, he continues to use his card as he would normally in March, making an additional $500 in charges.
When John receives his next month’s statement, he will see that he was charged interest on every purchase made in March. This is because the bank agrees to not charge interest only if the prior month’s balance is totally paid off. Since John had a balance last month (even though he paid it off on time), he is still being charged interest on all transactions made. He needs to pay his bill in total one more time to get back to not being charged interest on transactions.
This is why it’s critical to never run a balance on a credit card. If you end up having a balance and being charged interest, do not use the card at all until you pay off the debt and have a $0 balance on two straight statements.
Lubomirski: It’s pretty clear that even the smallest amount of credit card debt can snowball into something huge. In addition to extra interest, a large debt can have a negative impact on your credit score. I didn’t realize that it was so hard to stop the interest being charged if you just run a balance one time.
I think the bottom line is to avoid having unpaid balances at all costs. If you have credit card debt, address it as soon as possible by not using the card until you have the money to pay it off in full.