Be Aware of the Costs of Credit
Credit comes with risk and rewards, just like any financial decision for your business. By understanding the costs of credit, the dangers, the methods to get the best rates and the tips for lowering your credit costs, you can use this important business and personal tool to your advantage.
Despite what many naysayers decry, there are valid reasons for using credit. Using credit to purchase goods and services may allow consumers to be more efficient, more productive or to lead more satisfying lives.
Although using credit increases the amount of money that you can spend on goods and services today, it decreases the amount of money that you will have available to invest, to save or to spend later.
Weighing the Advantages of Credit
Consumer credit enables us to have and enjoy goods and services now and to pay for them through payment plans based on future income.
Credit cards permit the purchase of goods even when funds are low. If you have established credit, you are better equipped to cope with financial emergencies. Some people consider it safer to use credit cards rather than to carry large amounts of cash. Some people like the convenience of paying for several purchases with one monthly payment.
Credit can indicate stability. The fact that lenders consider you a good risk usually means that you are a responsible individual.
Weighing the Disadvantages of Credit
If you don't repay your debts on a timely basis, credit has many disadvantages. We can't overstate this enough. Perhaps the greatest disadvantage is the temptation to overspend, and continued overspending leads to serious trouble. Tied into that is the very real cost of a "loan" from the credit card company.
Whether or not credit involves putting up collateral, failure to pay a loan may result in the loss of income, valuable property and your good reputation. It could also result in court action, wage garnishment and bankruptcy. Misuse of credit can create serious long-term financial problems, damage to family relationships and a slowing of progress toward goals. Therefore, credit should be approached with caution and must not be used more extensively than your budget permits.
Credit costs money. Even with recent reforms, credit card interest is usually exorbitant—in the 15-25 percent range on balances that you carry from month to month. Making minimum payments nearly always guarantees that you will fall further and further behind in any effort to build wealth or to ensure future financial security.
Paying for your purchases over a period of time is more costly than paying for them in cash, especially as many vendors are now offering cash discounts. Also, although credit allows more immediate satisfaction of needs and desires, it does not increase total purchasing power. Credit purchases must be paid for out of future income, therefore, credit ties up the use of future income. Furthermore, if your income does not increase to cover rising costs, your ability to repay credit commitments will be diminished.
Know the Cost of Credit
Many people fool themselves (or live in denial) and think that the cheapest loan is the one with the lowest interest rate and the lowest payments. But that's not the whole story.
The length of the loan and the fees you pay are essential in figuring the loan's true cost. Moreover, with a credit card you may find yourself saddled with a higher interest rate at the whim of the bank—with an installment loan, the terms are fixed and can vary only within the terms of the contract.
You may have a credit card maxed out at its $5,000 limit. And because of other debt and slow sales you are only able to pay $100 per month. Also assume the current interest rate is 15 percent.
If you pay only $100 monthly without adding a single additional purchase, it will take you nearly 6.5 years to pay off that $5,000. At the end of that 6.5 year, you will have spent more than $2,700 in interest charges.
That's not the worst of it. In addition to paying all that interest, you've lost the chance to invest the money. If you had invested the average monthly interest charge over those 6.5 years in an investment that earned an eight percent return, you would have earned more than $1,750 in the same period of time. What did those credit card purchases cost you, really? Adding what you paid in interest ($2,700) plus what you could have earned in an investment ($1,750), your cost was about $4,450! That $5,000 credit card debt really cost you $9,450.
If you are thinking of borrowing money or opening a credit account, your first step should be to figure out how much it will cost you and whether you can afford it--long-term as well as short-term. To go this, you should shop for the best terms, especially for credit cards. To get the whole picture, you must consider all of the following factors:
Many Factors Determine Cost of Credit Cards
To find the exact terms of your credit card cost, you'll need to
refer to your agreement and the terms and conditions portion of your
monthly statement. Most people don't bother with the fine print, but if
they did, here's what they would find:
All credit cards are not the same. There's more to the cost of
a credit card than the annual fee and the interest rate on your unpaid
balances. Equally important are the grace period—the time between your
purchase and when you have to pay to avoid finance charges—and how the
interest is actually computed.
Some banks that charge low interest rates have no grace period. This
means that you start paying interest from the day you make your
purchases—even if you pay your bill on time. And that interest can add
up pretty quickly. On many cards, even if your balance is as low as $15,
you have to pay a minimum finance charge of 50 cents. That's a whopping
annual interest rate of 40 percent.
In addition to the annual fee and interest charges, companies may
charge extra fees for special situations. For example, if you exceed
your credit line, the bank may charge an over limit fee. If your minimum
payment is overdue, there's often a late fee as well. The clear trend
in recent years has been to increase the amount of these fees: late
payment and over-limit fees of $30 or even $39 are now common.
You may be able to save money by making informed choices regarding
which credit cards you use to make purchases, and cash advances, as well
as how much—and when—to pay on balances owed. Selecting a credit card
is one situation where the old adage "know thyself" is outstanding
To obtain the best credit card, you need to honestly evaluate your
spending habits and financial situation. And your honest answers may
sound like these:
You will need to carry a balance. Some people are certain
that they will be able to pay off their charge bills each and every
month. If you are not one of them, then the best card for you would be a
low-interest card. Getting one percent "cash back" on your purchases
might be nice, but if you pay an extra five percent interest on your
purchases, you are spending more than you are receiving.
You may not always be able to make the payments on time.
If your financial picture is such that you stand a good chance of having
late payments, make sure to carefully evaluate the late payment terms
and conditions. A late payment will cost you in fees, with some cards,
it could also cost you in a higher minimum payment or even an increased
You will pay off your balance each month. Being able to
pay off your balance each month means that you have the greatest variety
of options. For you, a "rewards card" or a "cash back" card might make
sense—particularly if the rewards are for items/services that you want
or if you can apply them to reduce your payments. However, even in this
situation, make sure that you select a card that allows a grace period
for new purchases. As noted above, you don't want to start paying
interest from the day of purchase.
Searching "credit card comparison" will turn up numerous websites
that let you quickly compare terms on a wide variety of cards. Many of
these sites exist to "match" you to an ideal card, but you can use them
to educate yourself without completing any applications on the websites.
Save Money by Knowing Your Credit Cards
In order to best use some of the strategies discussed, you will need
to compile some rather detailed information on each charge and credit
card that you own.
Although it may seem tedious to do so, you should list all of the
following information for each card. (Remember, MasterCard and VISA
cards issued by different credit companies can have different terms,
therefore each should be listed separately.)
- Type of card (VISA, MasterCard, etc.)
- Card number
- Name, address, and telephone number of issuing financial institution
- Expiration date of card
- Interest rate payable on account balances
- Grace period
- Annual fee (if any)
- Due date to make payments
- Credit limit/available credit (separate limits may apply to purchases and cash advances)
- Minimum monthly payment (computed as percentage of existing balance)
- Over-limit penalty
- Late payment penalty (and date when it applies)
Keep this information hidden at all times, whether it's stored in a
locked drawer or encrypted and password-protected on your computer.
Compiling this information will not only allow you to possibly use
some of the money-saving tips contained in this article, but will also
serve as a database of information to needed in case one or more of your
credit cards is lost or stolen.
When Interest Starts and How It Builds Determine Total Cost
The finance charge is the total dollar amount you pay to use credit.
It includes the interest costs and all other applicable costs, such as:
- service charges
- appraisal fees
- late fees
- minimum balance fees
- credit-related insurance premiums
Be careful to ask about all fees—they add up very quickly and can
substantially increase the cost of the loan. It is important to consider
the finance charge in making any intelligent credit decision.
Considering Interest Accrual
The length of time that the loan is considered outstanding, and thus
the length of time over which interest is due, is an important factor is
computing the amount of interest, especially on credit card debt.
Lenders use one of four basic methods to determine the amount of time
for calculating interest.
Be aware that lenders can use different methods for different types
of transactions. For example, a "cash advance" on a credit card is often
charged interest beginning with the day of the advance—even if there is
a grace period for purchases.
Past-Due Balance Method
This method is used to stimulate customers to repay their accounts
fully. Customers who pay their accounts in full within a specified time
period, such as 30 days from the billing date, do not have to pay any
interest. This is often referred to as the "grace period."
Previous Balance Method
This is the most expensive for the customer because interest is
computed on the outstanding balance at the beginning of the period and
does not take into account any payments that were made during the
period. If at all possible, avoid cards that you this method.
Average Daily Balance Method
The interest is charged on the average daily balance of the account
over the billing period. Using this method is less expensive than the
previous balance method and is widely used by lenders that offer
revolving charge accounts.
Adjusted Balance Method
The interest is computed based on the balance remaining at the end of
the billing period, ignoring purchases or returns made during the
billing period. This method will result in lower interest charges than
either the previous balance method or the average daily balance method.
Assume that the monthly interest rate is 1.5 percent, which
represents an annual rate of 18 percent. The previous balance is $400
and a payment of $300 was made on the 15th of the month. The finance
charge under each of the four methods is:
Past Due Balance Method: $ 0.00
Previous Balance Method: $ 6.00
Average Daily Balance Method: $ 3.75
Adjusted Balance Method: $ 1.50
Compound Interest Commonly Used for Consumer Interest
The two most common methods of calculating the interest portion of
the finance charge use the simple interest and the compound interest
Credit card interest is nearly always "compound" interest. However,
because of the Truth in Lending laws, credit card companies must
disclose the Annual Percentage Rate (APR) that they charge. So, for
credit card companies, the math is done for you. You just have to wisely
apply it to your situation.
Simple interest is the dollar cost of borrowing money. This cost is based on three elements:
- the amount borrowed, which is called the principal
- the rate of interest
- the time for which the principal is borrowed.
The formula used to find simple interest is:
|interest = principal x rate of interest x amount of time the loan is outstanding, or |
I = P x R x T
Suppose you borrow $1,000 at 10 percent simple annual interest and
repay it in one lump sum at the end of 3 years. To find the amount that
must be repaid, calculate the interest:
Interest = $1,000 x .10 x 3 = $300
This computes to $100 of interest each year. The amount that must be
repaid is the $1,000 principal plus the $300 interest or a total of
Unlike simple interest, compound interest calculates interest not
only on the principal, but also on the prior period's interest. The
formula for calculating compound interest is:
|Future repayment value = Principal X (1 + rate of interest)Amount of Time, or |
F = P (1 + R)T
The factor (1+ R)T can be obtained easily using a
spreadsheet a compound interest table. Most consumer loans use monthly,
or even daily compounding. Thus, if you are dealing with monthly
compounding, the "R" term in the above formula relates to the monthly interest rate, and "T" equals the number of months in the loan term.
Likewise, if the loan in question uses daily compounding, the "R" term relates to the daily interest rate, and "T" equals the number of days in the loan term.
Suppose you borrow $1,000 at 10 percent interest, compounded monthly,
and repay it in one lump sum at the end of three years. To find the
amount that must be repaid, you must first convert the 10 percent annual
interest rate into a monthly interest rate:
.1 (or 10%) / 12 = .00833
Plugging this number into the formula yields:
|F = $1,000 x (1 + .00833)36 |
F = $1,000 x (1.00833)36
F = $1,000 x (1.34802)
F = $1,348.02
The Basics of APRs
Some lenders charge lower interest but add high fees. Others do the
opposite. The annual percentage rate (APR) allows you to compare loans
on equal terms.
The APR is, by and large, the true measure of the effective cost of
credit. The APR is the ratio of the total finance charge, not just the
interest charge, to the average amount of credit in use during
the life of the loan and is expressed as a percentage rate per year. The
calculation of the APR depends on whether the loan is repaid in a
single payment or in installments.
All lenders are required under the Consumer Credit Protection Act to
disclose the effective annual percentage rate as well as the total
finance charge in dollars.
Calculating APR on Single-Payment Loans
A single payment loan is paid in full on a given date. There are two ways of calculating APR on single payment loans:
- the simple interest method and
- the discount method, which uses the formula: APR = Average annual finance charge/Amount borrowed.
Raymond borrows $1,000 at 10 percent for one year. There is a $25
application fee. The finance charge is $125, the interest plus the
Under the simple interest method, the total principal plus finance charge must be repaid at the end of the year.
APR = $125/$1,000 = 12.5%
Under the discount method, the finance charge is deducted from the
amount of money loaned. So you get, and have the use of, only $875, the
principal minus the finance charge.
APR = $125/$875 = 14.3%
There are several methods for calculating the APR on installment loans.
The actuarial method is the most accurate in calculating the APR and
the one lenders most use. It can be defined as interest computed on
unpaid balances of principal at a fixed rate, with each payment applied
first to interest and the remainder to principal. Because calculation by
this method involves complicated formulas, many small business owners
rely on annuity tables, computer programs or financial calculators.
The constant-ratio method is used to approximate the APR on an
installment loan by the use of a formula, but it overstates the rate
substantially. The higher the quoted rate, the greater the inaccuracy.
The direct-ratio method uses a somewhat more complex formula but is
still easier than the actuarial method. It slightly understates the APR
as compared to the actuarial method.
The N-ratio method gives a more accurate approximation to the APR
than either the constant-ratio or the direct-ratio method for most
loans. The results of the N-ratio method may be either slightly higher
or lower than the true rate, depending on the maturity of the loan and
the stated rate itself.
Anne borrows $1,000 to be repaid in 12 equal monthly installments of $93. This represents a finance charge of $116.
[($93 X 12) - $1,000 = $11 ]
The APR calculated using each method is:
Actuarial Method: APR = 20.76%
Constant-ratio Method: APR = 21.42%
Direct-ratio Method: APR = 20.62%
N-ratio Method: APR = 20.76%
Early Repayment Provisions Vary Based on Type of Credit
When deciding whether to pay off closed-end loans early, you should
know how much interest you'll save. You may be better off investing the
funds elsewhere rather than prepaying the loan.
For many loans, lenders use tables based on a mathematical formula
called the Rule of 78's, or sometimes, "the sum of the digits," to
determine how much interest you have paid at any point in a loan.
The Rule of 78's is illegal under federal law for closed-end consumer
loans longer than 61 months. This means that a lender cannot use the
rule of 78 to front-load your finance charges for consumer loans of 5
years or more. In addition, many states have made the practice illegal
for closed-end consumer loans with a loan term of 60 months or less.
You can find the law that applies in your state by searching for rule of 78s and [your state's name] (e.g., Rule of 78s Illinois.)
If have a loan that is fewer than 61 months (5 years) old and are not
in a state that bars the use of this formula for shorter-term notes,
this formula dictates that you pay more interest at the beginning of a
loan when you have the use of more of the money and that you pay less
and less interest as the debt is reduced.
Because all payments are the same in size, the part going to pay back
the principal increases as the part representing interest decreases.
The Truth-In-Lending Act requires that your lender disclose whether or
not you are entitled to a rebate of the finance charge if the loan is
paid off early.
To calculate the amount of interest attributable to each payment
under the Rule of 78's, first, add up all the digits for the number of
payments scheduled to be made. For a 12-month loan this would be 1 + 2 +
3 + 4+ ... + 12 = 78. In the first month, before making any payments,
you have the use of the entire amount borrowed. You thus pay 12/78 of
the total interest in the first payment. In the second month, you pay
11/78; in the third, 10/78; and so on down to the last payment, 1/78.
Likewise, the sum of the digits for a four-year (48 month) loan would be
1 + 2 + 3 +...... + 47 + 48 = 1, 176, and you would pay 48/1,176 of the
total interest in the first payment, 47/1,176 in the second month, and
To calculate how much interest will be saved by prepayment, you
merely sum the digits for the remaining payments and multiply the
fraction by the total amount of interest that must be paid on the loan.
Liz borrowed $3,180 ($3,000 principal plus $180 interest) for 12
months, with equal monthly payments of $265. Because of the "sum of the
digits rule," if she repays after six months, she will only save $48.46,
not $90 ($180 * 6/12) as you might expect.
Sum the digits: 1+2+3+4+5+6 = 21
$180 x 21/78 = $48.46 interest saved.
Tips for Lowering Credit Costs
Depending on your financial situation, and how you use credit cards, some of the following tips may save you money.
Pay Off Charge Card Balances as Quickly as Possible
Ideally, you should pay off all your credit cards each month. But, if
that's simply impossible, don't let the credit card companies keep you
in debt forever.
A key part of your credit agreement relates to the minimum payment
that must be made each month to keep the account current. While a low
payment requirement gives you the flexibility of making smaller monthly
payments, it comes at a hefty price: By making smaller payments, you
extend the time period in which you will go on paying interest.
This will increase the total interest that you must pay. Depending on
the interest rate and minimum payment provision that applies to a
charge card, if you make only the minimum required payment each money,
you might not pay off the balance for over 20 years!
Pay Off High Interest, High Fee Card Balances First
If you have enough money to pay more than the minimum amount due on
at least some of your credit cards, you'll save money by first paying
off the cards that charge the highest interest rates and other fees.
Charge New Purchases on Lower Interest-Rate Cards
If you can't pay in full within the grace period, charging on the
lower rate cards will save money on interest charges. If you have many
credit cards, carry only the ones that you may need for emergencies
(such as gas and telephone cards).
Only a few selected store or bank cards, arranged in such a way in
your wallet or purse to remind you which cards offer the lowest rates
(lowest rate cards on top?).
Avoid Late Payment and Over-Limit Penalties
If you find yourself strapped for cash to make all of your charge
card payments on time, you can use the information that you compiled
about your credit cards to figure out if you can save money by paying
some of the cards (the ones that impose the highest fees) before the
fees fall due, and delay payment on some of the others.
This is, at best, an imperfect solution, since habitual late payments
will adversely affect your credit rating. But it might help you weather
a cash flow dry spell.
Be very wary of this strategy and do not attempt it without knowing
all the facts about all of your credit cards. Buried in the fine print
on some credit cards is a cross-default provision. This means that if
you default on another creditor's payment, then the bank can increase
the APR on the money you owe to them.
Yes, even if you pay Bank Card A on time every month, a failure to
pay on Bank Card B, a gas card or even a utility bill means that Bank A
can jump your APR from 11.9 to 18.9 and apply that to your outstanding
balance with them. And, yes, nearly all credit card companies regularly
run your credit history looking for signs of trouble.
Rather than simply skip a payment, get on the phone with your credit
card company, explain your situation and ask for "permission" to miss a
payment. Many times the company will agree.
Use Online Payments To Avoid Late Fees
Setting up online bill paying for all of your creditors guarantees no
late payment fees, unless, of course, your withdrawal account has
In nearly all cases, you will continue to have the option of paying by "snail mail" if ever needed.
Negotiate for Better Credit Terms
If you are a good credit risk (you have steady and adequate income,
and a history of paying your bills on time), your existing credit card
companies want to keep doing business with you.
Because the consumer credit market is highly competitive, your
current charge card companies are not the only ones who would like to
have you as a customer.
So, if you have charge accounts that charge high interest rates
and/or high fees, consider trying this: Call up the company and say that
you intend to close the account and open an account with a competitor
who offers a lower rate (or no yearly fees). It would be helpful if you
have done some research and can quote competitors' rates.
If you are a valued customer, the company will often offer to lower
the rates that it charges you for future purchases, and may lower or
eliminate the yearly fees. This strategy is not for the timid, and, to
be most convincing, you probably should be ready to make good on your
threat to take your business elsewhere, if you're not satisfied with the
credit company's response.
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