Take an Interest in Interest

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Authored by Sallie Krawcheck of Ellevest, the article entitled, 4 Things To Do Before Investing puts forth four essential actions a potential investor must take before taking the big leap into the investment world. Ranking in at number one, Krawcheck advises that all potential investors first, “…pay off any high-interest rate debt you have before you do anything else. So no passing go, no collecting $200 until you've ditched the debt. We're talking about credit cards or double-digit interest rate loans here.” While it can be tempting to hang onto debt while attempting to grow your money, it is crucial that we take a closer look at the true cost of debt.

In a 2014 poll conducted by Gallup, it was found that about half of American credit card users sometimes carry a balance on their cards. If you’re one of those millions of users, you’ve borne witness to the interest charges that can accumulate on your monthly card statement. Searching out the current interest rate of each of your credit cards is a powerful first step towards knowing whether interest has taken a favorable or adversary role in your own financial life. For that, let’s examine what credit card interest really is and how it is calculated.

Insight into the World of Credit Card Interest

Credit card purchases are subject to a standard interest rate called the Annual Percentage Rate, or APR. This number varies from card to card and person to person depending on factors such as credit scores. Your APR is treated on a yearly basis but charges are calculated monthly. Just like “miles per hour” measures speed over an hour, APR measures interest over the time period of a year.

To find out how much interest you’re paying on your credit card balance each day, try this formula:

Convert your APR to a daily percentage rate by dividing your APR by 365 (the number of days in a year).

At the end of each day, card issuers multiply your current balance by the daily rate to come up with your new daily interest charge. That charge is then added to your balance the next day, a process that is referred to as compounding.

Here is a more visual example:

Credit card = APR of 15%

Daily rate = .041096%

Your balance = $1,000 (at the 15% APR standard interest rate)

New balance after interest is added from the previous day = $1,000.41 (plus any additional purchases and minus any new credits or payments).

This same process occurs each day until the end of your monthly statement cycle. If you begin the month with a balance of $1,000, that balance then becomes $1,013 when interest charges are applied at the 15% APR.

Insights to also consider:

  • Separate interest rates and charges can apply to cardholder’s cash advance balance and balance transfer balances.

  • Many credit cards impose a higher penalty interest rate when cardholders fail to make payments.

  • Certain credit cards (particularly store cards) have an "intro period" of 0% - as long as the ENTIRE balance is paid off before the end of the intro period. If even a tiny balance remains at the end of the intro period, then all the accrued interest you would have otherwise paid at the higher non-intro rate would be charged to you.

  • Most credit card variable interest rates can change with the Prime Rate. The Prime Rate is an interest rate that is three percentage points above the federal funds rate, which is set by the Federal Reserve Bank. Because this interest rate can increase, the cost of credit can also dramatically increase.

Crunch Your Numbers

With this formula in mind, what price are you paying for the credit cards in your wallet?

The Silver Lining of Credit

One of the few phenomenal things about credit card interest is that credit card companies usually grant borrowers a grace period. If a grace period applies to your own credit card, the issuer will not charge you interest on purchases if you pay your entire balance by the due date each month. Conversely, if as a cardholder, you fail to pay the entire statement balance, or don’t make the payment in time, you have then forfeited your grace period and the interest charges will typically roll into the next statement. *Always check your card member agreement for details specific to your account.

Remembering these facts and figures of credit card interest can empower you and give you a greater understanding of how interest can be hurting or helping your own financial situation.

Keep More of Your Money

Credit card interest is the principal way in which credit card issuers generate revenue. By making more informed decisions when it comes to the pros and cons of utilizing credit, you are better able to keep more of your money in your own pocket.

Compound Interest Can Be a Great Friend

On the flip side of credit card interest is the interest that can work in your favor to grow your money by earning interest on your interest. One of the most common ways to earn this type of interest is by depositing funds into a savings account that will generate interest on that money. Take this for example:

If you deposit $1,000 set to earn 2 percent a year in compound interest, at the end of year one, you would end up with $1,020. For year two, you would earn interest on the entire amount, so you would end up with an extra $20.40, instead of $20. That money would then be added to the total, for $1,040.40. If you didn't add any money, letting it sit for 40 years, you would end up with $2,208.04.

Is Interest Helping Or Harming Your Financial Life?

As illustrated by the various example of compound interest, this is a mathematical unicorn that can be your greatest ally when it is working in your favor in either retirement, savings or investment accounts. On the contrary, it can prove to be your greatest adversary when it’s in the form of private student loans, personal loans, or unpaid credit card balances.

Take the Next Step

Assessing your current financial situation and taking stock of your numbers in relation to interest serves as an indicator to the appropriate money moves that you can make to more effectively accelerate your financial journey.

Since credit cards generally have significantly higher interest rates than savings or investment accounts, it is often advised to tackle these balances before jumping into the investment game.

Once you have done the work of crunching out your own facts and figures in the money department, knowing who to trust with that money can be an easy decision when you know what to look for.

To learn more about this and other money tips, download our FREE ebook “How to Become a Confident Inversionista and Start Making Your Money Work for You” made in collaboration with Ellevest.