How to Understand Credit Card Interest
We always hear about credit cards and the interest they carry. Credit card interest is basically extra money that is owed to a credit card company as a fee for the loan it is giving you. This number is expressed as an annual percentage. Personal finance experts always say you should try to pay extra on your outstanding balances to pay less interest, but what exactly does that mean?
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Instructions
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Look at your credit card statement and write down your outstanding balance, minimum payment terms and interest rate. Write or type those figures in your spreadsheet or graph paper.
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Multiply the interest rate by the total balance to determine your yearly interest at this point. For example, if you have an interest rate of 20 percent on a balance of $2,000, your yearly interest is $400.
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Divide the yearly interest by 12 to determine your monthly interest. Monthly interest based on $400 yearly interest, in the example above, is $33.33. This is the amount out of your minimum payment that will go to interest. The remainder will go toward paying the principal balance.
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Figure out what your minimum payment will be. This is usually a percentage of your balance or a small dollar amount, whichever is higher. For this example, let's say the minimum payment is 3 percent of the total balance or $10, whichever is higher. So the minimum balance this month will be $60 (3 percent x $2,000).
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Subtract the monthly interest from the minimum payment to calculate the amount that will be subtracted from your principal. In this case, you will be putting only $26.67 against the principal out of a $60 payment. Therefore, next month the new balance will be $1,973.33.
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Repeat this calculation for each month using the new balance multiplied by the interest rate to get the new yearly interest and dividing by 12 to get the new monthly interest. Calculate the new minimum payment as a percentage of the new balance. Subtract the new monthly interest from the new minimum payment to get the new amount you will be paying toward the principal. Make these calculations to determine how long it will take to pay off the credit card by paying the minimum balance. In this example, it will take 184 months.
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Add $10 to your minimum payment each month to see how it affects your payoff time. In this example, you would now pay $70 instead of $60. Subtract the $33.33 from the $70 to get the new amount you are paying toward the principal, which is $36.67.
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Calculate the payoff schedule using this added money. In this example, by adding $10 to the minimum payment each month, you will pay off your credit card debt in 97 months, or seven years earlier. This will also save you thousands of dollars in interest. Play with the numbers to understand how the interest affects your minimum payments and principal balance.
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Tips & Warnings
This calculation becomes much easier with a spreadsheet, although it can be done by hand with a calculator. But if you have a spreadsheet program, use it.
This is only meant to be a guide to understanding how interest affects your payment time. Keep an eye out for a reduction or increase in your rate, as this will change all of your calculations.
References
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