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Understanding the Credit card rates and paying off the debt

Why is the credit card popular?

The credit card is a popular way of spending money on shopping and other purchases. These cards issued by banks and other financial institutions allow you to spend first and then pay later. This is what makes it highly convenient. You get sufficient time (usually 30 to 45 days) to pay the amount you have spent. The reason for the popularity of credit cards is that even if you do not have money in the bank, you can still spend it using your card.

All you need to do is pay the minimum amount due every month. For example, you may have spent 1000 using your credit card. You need not pay the entire amount, you can only pay the minimum due, which may be 20 or 30. You can keep paying the due amount every month until the payment is complete. However, you need to keep in mind that you would be charged interest if you don’t pay the entire credit card bill within the 45 days credit period.

The credit card company is essentially loaning you an amount for your needs. The loan is interest-free for a limited duration, after which you need to start paying interest. The interest amount charged is the highest in the market. When you work out the costs, you would realize your credit card spending is too much. The lure of the card though makes you spend every month leading to a huge bill and outstanding amount piling up.

Repaying only the minimum amount leads to build up of a big interest payment. Failure to pay can lead to legal action and can severely affect your credit rating, putting you in trouble if you want a loan later. The solution seems simple – don’t use credit cards! This is not easy as most people find it difficult to balance their budget. Using credit cards would help in managing expenses. You need not give up your credit card but need to know how to use it in a wise way.

The following is information on how your credit card works, what are the rates charged and related information. This would help you plan on paying off your debt easily. Whether you are planning to get a card or already have credit cards, this information would be handy for you.

How the credit card works?

The credit card is where you are loaned money by the card issuer for your expenses. It is different from a debit card, where you are spending the money that you have in your bank account. A credit card gives you a credit limit, which is the upper limit of the amount you can spend on the card. There is no fixed rule to decide the credit limit. It is based on the salary/income source information you provide the card issuer. It is also based on your credit score. Your credit limit can be enhanced based on your card usage.

If you have a credit card limit of 70,000 it means you can spend a maximum of 70,000 at a time. This is the loan you are taking on your credit card. Most credit cards allow you between 30 to 45 days before the bill is generated for the money you spent. They have a billing cycle and a due date, both of which are usually different. The billing cycle may be from 15th of one month to 15th of another. However, the bill would be due on the 30th. Let’s understand what this means.

Understanding the calculations

Let us assume you buy something for 2000 on the 16th of July. On the 15th of August, the bill would be generated indicating that you need to pay 2000. However, you need not pay the amount immediately, you would be given time until thirtieth of August, which is the due date for payment. You need not pay the entire bill amount of 2000 by that date. You can pay just the minimum amount due.

Generally, the minimum amount is 2% or 3% of the bill value. This again depends on your card issuer. 3% of 2000 is 60. So, this is all you need to pay. When you pay 60, you have not cleared your bill in full and hence need to pay interest on the amount. This is decided based on the APR or Annual percentage rate. It could be anywhere from 16% to 20% as decided by your bank. You need to pay 20% interest for2000, until you clear the payment. Let’s look at how the numbers stack up.

Amount spent =2000

Minimum amount to be paid =60

Interest @20% on the amount =400, 33.33 per month

Therefore, for the 60 you pay, 33.33 goes towards interest and the balance 26.67 is repayment of the principal. The balance due for next month is 2000 – 26.67= 1973.33. This calculation is repeated next month to calculate the amount due.

In this way, you would keep paying until you clear the principal and the interest. If you pay only the minimum balance of 60 every month, you would need 15 years to clear the 2000 you took. You would have paid a total 4,241. This means that the interest you paid is more than the amount you spent.

This calculation is for one month’s spending. Next month, you may again spend 2000 and in the next bill, you need to pay 60 for the previous bill along with 60 for the present bill. The outstanding amount keeps increasing as you keep spending. This is a typical debt trap that you can get into if you use your credit card more and pay only the minimum balance. However, it is not necessary that you pay only the minimum balance, you can even pay a higher amount. If you pay 70 instead of 60 in the above example, you can repay your amount due in lesser time. The more you pay each month, the lesser will be the interest you pay overall.

The best way to use a credit card is to pay off the entire balance by the due date. If you have a bill of 2500, pay it off in full. You would then not be charged any interest. This allows you 30 to 45 days of interest-free credit. Instead of spending money from your account, you can spend using your card and pay up after the credit period is over. This allows you to earn interest for 45 days from your bank account. It may be a small amount that you save, but small amounts do count. The best way, therefore, to use credit cards is to clear the bill in entirety.

In practice, this may not be possible. Most people overspend on their credit cards. Even if they do not have money in their account, they spend without worrying about where the money would come from. This leads to an increase in the amount you need to pay. The outstanding bill amount would carry interest. Remember late payment can lead to penalty, which is apart from the interest.

This problem compounds if you have more than one credit card. To get the advantage of an enhanced credit limit, you may apply for more than one card from different agencies. Each card may have a limit of 70,000. So, you can spend 140,000. If you use the entire limit, you would have to pay an interest of 2333.33 every month. Most people do not make this calculation. They spend recklessly and realize what they have got into only when the bill amount starts spiraling out of control.

It is also possible that the minimum amount you need to pay can increase. This may happen for any one of the following reasons:

  • You missed a payment or paid less than the minimum balance, leading to a penalty being charged.
  • You owe more as you have spent more.
  • You crossed your credit limit and hence are charged a penalty.
  • The card company has increased the interest rate.

If you are caught in such a situation, where your outstanding amount is higher than you can afford, then this is a situation that calls for immediate attention and action. Remember, non-payment of the minimum balance would lead to a penalty, which keeps shooting your monthly bill up. If you don’t pay, your credit ratings are lowered and you may be sued by the card issuer.

So, what do you do in such a situation? Here are some ways you can clear off your credit card debt.

1) Calculate the outstanding due

You need to calculate the outstanding amount from your present bill for each of the credit cards you own. You can even access your credit score report to get a clear understanding of how much you owe. Once you know the amount that needs to be paid, you can plan how you to pay it off. You would have other expenses too. So, you need to work out how much money you can spare to clear off your debts.

2) Lock up the cards

If you are in big debt, then you have no option but to stop using your cards. Lock them up so you don’t have easy access to them and are not tempted to use them. Spending using a credit card can be addictive. When you already have a big debt to pay off, using your cards again can be disastrous. How much ever it is difficult, stop using your card.

3) Cut expenses to generate money to pay your debt

It may be difficult to increase your income to generate money to pay your outstanding. The only option is to reduce your expenses. It is not difficult, you just need to do it in a planned way. Until you clear off your debts, you can drastically cut down on your eating out, movie watching, and mall visits. You can go through your monthly expenses and look at how you can reduce them. Look for places where you get discounts on your groceries. Every single penny you save is important. You can use the saved money to pay off your debts. Once you are debt free, then you can return to your life of comfort. Until then you need to make sacrifices.

4) Use the avalanche method to pay off debts

The avalanche method can be used if you earning more than your debts. Here you would first clear off outstanding on the card that charges the highest interest. Once you are done with that, you can then turn to the card that charges a lesser interest. In this way, you build up on your payments, until you clear it all.

5) Try the snowball method

The snowball method is slightly different. Here, you would pay the minimum amount on all your cards. You would then use the remaining money to pay off the card that has the least outstanding. Once this is done, you pay off the next card with the lowest amount due. You would continue this until all the payments are made.

6) Use a balance transfer card

A balance transfer card is a credit card that offers 0% interest. This would not be forever, but for a limited period of time. Once you get such a card, you can transfer the due amount from the other cards. You would have to pay a transfer fee, which may be around 3%. Once you transfer the amount to the new card, there is no interest to pay. This will help you quickly clear the principal amount. You must note that that 0% interest is for a limited time, you need to take advantage of this and clear off your debts during this time.

Use any of these methods to clear off your debts so you can be debt-free. The credit card is a boon, but if not used properly would turn out to be a curse.