A Short Lesson on Credit Cards

Many people who use credit cards understand how they work, but many don’t. I was teaching a class on this the other day and a student of mine pointed out that she thinks her parents don’t know about what I was teaching, and suggested I write an article. So I thought, why not? The math can get a little confusing, so I’ll avoid most of it and just give the answers.┬áKeep in mind this is a lesson I do with high school students, so I ask your forgiveness in advance if you read the whole article and never encounter anything you didn’t already know.

First things first. If you pay your credit card balance in full before the due date each month, you win. You are not paying any interest at all. So for example if you bought something at the beginning of your credit card cycle for $1000, the bank actually lent you the money to buy it without charging any interest, meaning you have owned something for a month before you had to pay for it, and it was at the complete and total expense of the bank. Not bad. In fact, if you really want to be clever, you can buy a $5000 television, charge it to your credit card, go from the store to the bank and deposit $5000 into a one-month GIC, and when the credit card statement comes withdraw the $5000 from the GIC to pay the bill. The GIC will have earned interest for a month so in effect that bank will have paid you to watch their television for a month. Nobody does this really, but in theory there’s no reason why you could not. Pretty cool.

So for people paying their balance in full each month, more power to you! Especially if you have some sort of points earning system on your card, which I’ll get to shortly.

Now for those who do not pay the balance in full, a short lesson on what happens. First, I’ll explain what the banks do about the interest.

As I said before, when people pay the balance in full, interest is never charged. But that doesn’t mean it’s not calculated — it really means it’s forgiven. So a purchase made 20 days before the statement date does accrue 20 days of interest (accrue means interest is added on), but it’s forgiven if the balance is paid in full. On the other hand, if the balance is not paid, that 20 days of interest kicks in.

I’ll use an example showing a just a few purchases. Here goes.

Assumptions:

  • No balance at beginning of cycle
  • Credit card interest rate is 20% (most are slightly below this as I type, but not significantly so — contrast that with current prime lending rate in Canada which is 1%!)
  • Cycle runs from January 1st to February 1st
  • Minimum payment due to credit card company is 3% of the outstanding balance (this is normal).

Purchases:

  • January 1: $2500 on a 54-inch LCD 3D TV. Great deal post holiday.
  • January 5: $400 on 3D DVD’s. Turns out watching regular TV on a 3D TV is a tad boring.
  • January 7: $200 in snacks from Costco for the Avatar party you’re hosting at your place.
  • January 10: $50 for a new pair of 3D glasses — turns out you can’t drop them in a punch bowl and expect them to still work.
  • January 18: $300 for a new XBox 360 gaming system because you ran out of 3D movies to watch.
  • January 25: $200 for new games because it turns out the one your XBox came with kind of sucks.
  • January 31: $150 for cool Halo controller, with helmet.

For the record, you spent $3800 using your credit card. Now suppose the minimum payment is $114, which is 3% of your outstanding balance (this is normal), and that’s all you pay. The credit card company requires that you make this minimum payment to avoid penalties, but they don’t really explain about how you’ll be penalized anyway with interest.

Here’s what happens. Your balance the moment the $114 is received by the bank will not be reduced to $3800 — $114 = $3686 as you might expect. In fact what will happen is your balance will immediately have $66.49 in interest added to it.

So your actual new balance will be $3752.49.

But it gets worse. You see what happens is that all your purchases starting with the very first one were interest-forgiven until the moment you didn’t pay the full amount. At that point what the bank does is they subtract your payment from the earliest purchases (in this case from the $2500 TV purchase), then they convert the 20% interest to a daily rate, which works out to about 0.07% per day, and calculate interest on each purchase using the number of days since the purchase was made. And the clock keeps ticking, so that by the end of the next statement period, which would be March 1, another 28 days of interest accrues on the balances. That would be another $71.03 bringing your balance up to $3823.51, not including any purchases you make in February. And in case you didn’t notice, your $114 payment has been completely eaten up by interest after only 28 days, plus you now owe $23.51 more than you spent. That’s after only 1 month and having made a payment of $114!

It gets even worse, if you can believe it. The purchases you make in February will be interest forgiven until March 1, however because you have old purchases from January on your account now, any payments you make on March 1 are applied to those purchases first, starting with the oldest, and that means that your February purchases are that much harder to repay in full, which in turn means that they will start accruing interest the same way your January purchases did the moment they are not paid in full.

When you consider that on March 1 you have to pay for all your January purchases, plus an extra $23.51 before you even have a chance at paying for your February purchases, you can see how difficult this gets, and how quickly it can spiral out of control.

OK. So lesson number one is always pay your balance in full. It’s the most important lesson about credit cards. So important that if you can’t do it, you should not be using your credit card at all. You will quickly max out your credit limit and then lose the ability to use it for purchases, and simultaneously be saddled with huge interest charges that you’ll have to manage.

At this point many people say that credit cards are evil and they should not be used. “If you don’t have the money to pay for something don’t buy it” they say. “Always use cash” is the motto for these people. They make a lot of sense, but they are wrong. Further, not only are they wrong, they are for the most part overpaying for their purchases!

You’ll have to allow me to explain that part. It seems to make no sense at all.

So here’s the deal. When a merchant decides they want to accept credit cards as a form of payment, they need to get a merchant account. They’ll generally rent a terminal from the bank to process the transactions. They also pay a merchant fee to the bank for every transaction, generally 2%-4% of the sale price, which means that they earn less on purchases paid for by credit card than they do on purchases paid for in cash. At the end of a day of business the bank will deposit the total for the credit card transactions less the merchant fees into the account of the merchant. So it costs the merchant money to accept your credit card, which is money they will do their best to build in to the price of the goods and services they provide, to the extent that they can without overpricing.

For most merchants this is a cost of doing business and though they may not like it they accept it for what it is because many customers will shop elsewhere if they can’t pay by credit card. It’s also part of the reason why some stores offer a discount if you pay in cash. Sure cash is harder to trace, but beyond that a merchant can afford to sell a product for cash at a lower price and still make the same profit or even slightly more if the offered discount is less than the merchant fee. So there’s a slight over-payment when you pay full price in cash for something that you could have used a credit card for, but it’s not really fair to categorize it that way since if you pay with a credit card that over-payment disappears and in either case you have received a good or service for the same price. So that’s actually not what I mean when I say people who pay in cash are overpaying.

The over-payment I’m referring to actually has nothing to do with the merchant. It’s really the points on the credit card that you miss out on when you pay in cash. Most credit cards today have some sort of points system attached to them whereby you accumulate points through purchases and then redeem them for merchandise or travel. For example earlier this year I paid for a return flight to Kelowna, BC and 4 nights in a hotel all with points.

Stop and think about that. The airline didn’t give the trip away. They can’t afford to. The hotel didn’t rent the room for free for the same reason. Both the airline and the hotel were paid by Visa. But where did Visa get the money? Not from me — I pay my statement in full so I never pay interest, which means Visa pays for my stuff then I give them the money back at the end of the month so they break even. Aside from my annual fee of $60, Visa is not making profit directly from me. The answer to where they get the money is the interest of other credit card holders mostly, merchant fees and annual cardholder fees. That’s $60 annually from me.

So what? Well let’s say in a year I spend $100,000 on Visa on some list of goods and services, and someone else spends $100,000 in cash on the same list. At the end of the year my wife and I go to Vegas and stay at The Venetian, all on points, a trip which would cost around $3000 in airfare and hotel. Mr. Cash does the same, but pays cash. They have now spent about $103,000 or so, but I’m at $100,060 (remember to add my annual fee) and we’ve gotten the exact same stuff. If you think a little more about it, if I spent $100,000 on Visa then the merchants where I shopped paid 3%, or $3000 of that in merchant fees. There’s the money for the trip. But the important part is Mr. Cash spent $103,000, and I spent $100,060

See? The cash payer overpaid.

Of course, if you don’t pay your balance in full each month all bets are off. In that case you would be paying for my trip to Vegas. And nice as that is, I don’t expect you to do it.

The moral is, put everything you possibly can on a credit card with a points system. Pay all your bills with it. Buy a car with it! But always always always pay your balance in full (if you can’t pay your balance don’t buy the stuff). You’ll be surprised at the “free” things you get and none of those things would come to you if you pay in cash.

Thanks for reading,

Rich