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How Do Credit Card Companies Calculate Interest?

Is it time to celebrate? Did you just get your first credit card and now you’re wondering how the interest will work? Or have you been using credit cards for a while and starting to wonder why your balance never seems to go down even though you’re making your minimum monthly payment on time every time? Credit cards can come chocked full of different fees and terms, and even interest rates. Interest rates can be fixed or variable, or even temporarily fixed for a short amount of time before switching to a variable. They can change on what seems like a drop of a dime, or depending on your spending, and payment behavior.

Credit cards can be really confusing, especially if you’re new to the line of credit game. The majority of credit card companies are sure to put all of the details explaining your card in detail deep in the fine print. For any card you have currently or considering applying for, it’s best to make sure you know the terms the card company is offering inside and out. But if you can’t do that, or just don’t have the time, there are a few minimal pieces of credit card knowledge you should stock your brain with.

The most important of these pieces of knowledge, perhaps, is knowing how credit card interest works in terms of billing cycles and compounding methods. Most people have credit cards, and at least half of credit card owners carry a balance which is subject to interest. Credit card interest is spoken of in terms of APR (Annual Percentage Rate). The interest rate can vary from card to card and from time to time. And they definitely vary from person to person based on each person’s credit score.

Calculating Interest

APRs are identified in terms of a year. But your daily interest rate is a different number. To find out what you’re paying each day in terms of interest, simply divide the APR by 365 days. So if your card carries a 14.95% APR, divide 14.95 by 365 and you see that you are paying 0.0409589% interest on a daily basis. So if you carry a balance on one day of \$495, the interest the credit card company will charge you for that day is \$495 x 0.0409589% (or 0.000409589), which is \$00.20.

Compounding Interest

The next day, provided you haven’t made any new purchases or payments, your balance will be \$495.20. At the end of the day, interest is calculated again but, this time it’s calculated against the new balance. So, \$495.20 is multiplied by 0.0409589% or 0.000409589. Interest for this day comes to 20 more cents. Your total balance for this day is now \$495.40. The following day, 20 more cents is added to bring your balance up to \$495.60.

New Charges

What if you make a \$2000 purchase on your card, bringing the balance up to \$2495.60? What would be the interest at the end of the day you made this big purchase? The same rules apply. Interest is calculated daily regardless of the balance. The credit card will multiply your balance of \$2495.60 by 0.000409589 which is \$1.02.

Your balance at the end of the day will be \$2496.62. If you make no new charges and you have, let’s say, 10 days left in your billing cycle then, you’ll be charged \$10.22 in interest more before your next payment is due, bringing your total balance to 2506.84. You’ve made \$2495.00 worth of purchases and generated \$11.84 in interest for the credit card company over a 14-day period.

Variability In Interest Rate

Each card is unique. Some may come with very straightforward APRs, while others may offer one APR for purchases and another for balance transfers and cash advances.

Many card companies offer introductory APRs for terms of six months, a year, or other predetermined time periods. Then the APR adjusts after that period is over. If you do apply for a card of this nature, just make sure you know what the APR is after the introductory term expires.

Grace Periods

Some credit card companies do offer grace periods for a certain amount of time for each billing cycle. If you pay off your balance in its entirety each billing cycle before the grace period expires (usually by the payment due date), the credit card company will not charge you interest for that billing period. If you don’t pay your balance off in full, then the interest charges will appear during the next billing cycle. Not all credit card companies offer grace periods, so make sure to read the fine print of any credit card offer you receive.

Variable Rates

Credit cards often come in the form of variable rates. These variable rates fluctuate at a certain number of percentage points above prime. The prime rate is based on the federal funds rate, plus three additional points. Because the federal funds rate can fluctuate, your variable rate will fluctuate too. So just make sure if you are considering a card with a variable rate, the terms of the rate are something you are prepared to deal with financially.

The Minimum Payment

Credit card companies offer very low minimum payments for a reason. The less you pay off each month the more interest rate a credit card carrier can let accumulate in your account. While it may be saving your budget month to month to pay just the minimum balance, in the long run, you end up paying much more when you finally do end up paying off what you owe.

Also, your credit rating is done no favors by only paying the minimum each month. As your debt to credit ratio tightens, your credit score will begin to go down. That’s because a significant portion of your credit rating is based on the comparison of how much debt you owe to how much credit you have available. Paying off your balance is your surest bet to maintaining a high credit rating and paying minimal interest month to month.

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What is A Revolving Line of Credit

A revolving line of credit is basically an agreement between an individual or an entity and a bank or other financial institutions to borrow short-term money for a maximum fixed amount that is renewed when the balance is paid off or paid down. The bank will initiate a commitment fee the borrower must pay when opening the credit line.

When a borrower draws on a line of credit, interest expenses are charged. If charges are carried forward from month to month, then carry-forward charges are incurred as well. Revolving lines of credit are similar to personal credit cards, but they usually require some sort of collateral.

For individuals, this collateral may be an existing home or personal property. A home equity loan, aka HELOC, is an example of a personal revolving line of credit. The issuing agency uses your home as security provided you have a sufficient amount of equity in it, to grant you the credit line. If you default on your revolving credit, the house can be used as collateral to recover the value of the HELOC.

For businesses, revolving lines of credit are granted by creditors with inventory or accounts receivable used as collateral a majority of the time. If a company defaults on the revolving line of credit, the value of the loan can be recovered through the value of the inventory or accounts receivable.

Why Do Revolving Lines Of Credit Exist

Most of the time a person or company seeks a revolving line of credit need it to make up for shortfalls in revenue on a monthly basis. They may have Accounts Receivable outstanding or an influx of inventory. A revolving line of credit is a great way to add stability to any business that experiences a normal amount of financial fluctuation or is experiencing periods of growth that requires increased funding. Some take out credit cards to increase their credit score, for the points and rewards or to supplement their income. (see this article about How Many Credit Cards Should I have)

For individuals, revolving lines of credit such as home equity loans are a great way to consolidate debt at a lower interest rate than their current credit card companies are providing, or for making needed home improvements to maintain or increase the market value of a home. Homeowners often don’t realize the amount of money needed to keep a home in good condition and market ready. A HELOC is one way to mitigate this problem, given the right real estate market is in place.

Advantages Of A Revolving Line Of Credit

The nice thing about these types of loans is once you’ve been approved you never have to reapply. You won’t have to make payments until you actually draw money from the line, and you can repay it and reborrow it over and over again for usually up to about ten years with the option to renew.  Personal lines of credit most often fall between \$5,000 and \$200,000 for average consumers.

For individuals seeking HELOCs, the amount you’ll be able to borrow will depend heavily on the value of your home, your credit rating, and the credit rating of any co-borrowers. If you have an established credit rating that is ranked well, you may be able to borrow up to 85% of the appraisal value of your home minus how much you owe on the property.  Just be careful to read the terms of the loan, as many can have larger payments later in the loan repayment cycle, which can catch you by surprise.

Unsecured Lines Of Credit

There are also unsecured revolving lines of credit, similar to credit cards. These types of loans do not require collateral such as a piece of home property in a HELOC or an amount of inventory in a business line of credit. Credit cards are considered as unsecured revolving lines of credit.

With unsecured lines of credit, limits are typically a lot lower than secured versions, and the interest rate is considerably higher. This is because lenders are incurring more risk with unsecured revolving lines, so the money they make must be more secure.

Costs Involved

The fees and costs involved in obtaining a revolving line of credit vary significantly from lender to lender depending on the specific line of credit you’re looking to open. You’ll be charged a regular interest rate that will range depending on your credit score and whether or not your revolving line of credit is secured or unsecured.

Some interest rates fluctuate depending on the prime rate. If you obtain a credit line with an APR of prime plus 2 points, the amount of interest you pay will vary with how much the prime rate varies. Make sure your loan has a cap on how high of an APR you have to pay to protect you from potentially soaring APRs.

For home equity loans, in particular, the fees incurred can be numerous. You’ll most likely need to pay an application fee of between \$75 and \$300. You may also have to pay to have your home appraised, which can cost anywhere between \$150 and \$450. You may have to pay points depending on your credit score, each one of which is worth one percent of the credit limit of the credit line. Finally, you may incur closing costs fees similar to those you paid when purchasing your home, which may vary between \$75 and \$350.

Hidden Fees

Some plans also charge transaction fees each time you make a withdrawal, or an annual maintenance fee to maintain the line of credit. While not every revolving line of credit has all of these fees, most contain at least a few. Make sure you take the time to read over all of the fees and terms involved in a revolving line of credit and don’t be afraid to shop around. Be aware of all the fees, and make sure you’re only borrowing what you need so you won’t be tempted by additional funds that you really don’t require.

The best way to use revolving lines of credit is to help your business or the value of your home grow. Using a revolving line of credit to reinvest in your business or your personal ventures will help to increase the value of these entities and increase your financial security in the long run.

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How Many Credit Cards Should I Have?

In a world of instant gratification and reward, credit card companies play in a field ripe with opportunity. It’s no surprise the average consumer has between three and four credit cards each, when around every corner an offer presents itself to open a line of credit. Credit card companies go all out in enticing the consumer with cash back incentives, deep discounts, and valuable rewards points. For those individuals with great credit, the ability to rack up credit cards is even easier. But, what is the right number of credit cards to have? Is there even a right number? The answer completely depends on you.

Really, how many cards should I have? Depends on your goal …

The appropriate number of credit cards in one’s pocket has a great deal to do with personality and purpose. As more than half of the U.S population of credit card holders have maxed out at least one card, there’s good reason to take a step back and ask yourself what kind of consumer you are. You’ll need to know if you are the type of consumer who would be tempted to fill in the ample credit space between a zero balance and complete max out, or if you tend more towards keeping as low of a balance as you can.

Points & Rewards

If your goal is to chase those enticing rewards points, then more cards may be better, as long as you can effectively juggle the cards and maintain low balances on each, ideally keeping the balances below 30% on each. If you can achieve this and not be tempted to overspend, then there are a lot of deals to be had. Credit card companies are doing everything they can to attract your business, banking on the certainty that at least some percentage of those opening credit accounts with them will carry large balances.

Department Store Discounts

Credit cards for the larger stores you find yourself shopping at frequently may be a big help on your wallet, as most of these cards offer cash back after you spend a certain amount, or a small discount on every purchase. If you travel often, then cards that offer rewards points on flights or hotels can be of a great advantage to you. But for each of these cards, you never want to spend more than you can pay off each month.

Rebuild Credit

If your goal is to rebuild credit, then more cards aren’t going to help you(you may need credit repair). What’s most important is establishing credit history, i.e. how long you’ve had each line of credit, timely payments, and low balance to limit ratio. Chances are, if you’re rebuilding credit, the cards you’ll qualify for at first won’t be ones with the best terms. Once you’ve owned these long enough to see your credit score climb back up, you can negotiate different terms, or begin to open new cards. Keep in mind though, each time you apply for or open a new line of credit, you can experience up to a five point hit on your score.

Emergency Reserves

If your goal is to have a card in case of emergencies, then limit how many cards you designate for that purpose. Choose a card that has the best benefits, such as no annual fees and no penalties for minimal balances. As the goal is to never use an emergency card in the first place, work on putting a little amount each month into savings as an alternate emergency fund. So when the emergency comes up, you have a starting fund to help pay off the card quickly.

Credit Cards and Your Credit Score

Technically speaking, the actual number of cards you own has very little impact on your credit score – 10% of your total score is dependent on this number, and that’s in combination with other lines of credit. So 10% of your overall credit score is dependent on the the number of credit lines (revolving, mortgage, auto loan, student loan, etc.) you have.

Here’s the breakdown, according to Investopedia:

• Payment history is 35% of your credit score
• total debt owed is 30%
• length of credit history is 15%
• new credit taken on is 10%
• type of credit used to include all types of credit is 10%

Given that your credit score is taking into account all forms of credit, extra credit cards may be a big help if you carry very low balances on them. The collective credit limits on those cards will help offset outstanding auto, personal, and student loan balances.

If you plan on playing the credit card shuffle to maximize points, just be aware of the open account vs. closed account factor. FICO will take your closed accounts into play when determining your credit history. But, a closed account also lowers your credit-to-debt ratio. If you have seven or eight cards already, this isn’t a problem. But, if you only have a few, you may want to give closing an account careful consideration.

The other thing to keep in mind about the credit card shuffle is the importance of remaining active on those cards. Many cards carry minimum spending requirements to avoid any penalties, and many of these companies will close your account for inactivity. Closed cards means lower debt-to-credit ratio.

In Closing

Ultimately, there is no wrong number when it comes to how many credit cards you choose to have in your wallet. Whether you choose to have cards for rewards, to build or repair credit, or for emergencies, just be honest with yourself before taking the plunge. Know what kind of spender you are, and do your homework on the best and worst deals you can find in the credit card world.

And remember, the more cards you have, the more accounts and bills you’ll need to keep track of, including being aware of spending minimums and annual fees. Knowing your options and how they affect your credit score will be the biggest help to you in making your decisions about how many cards to own.

What are your thoughts? How many cards to you juggle and why?

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