What Is the True Cost of Credit?

  • 5 min read

When you’ve got a credit card in your wallet or purse, then you’ve got some flexible spending power that can help you get out of an emergency quite effectively. It may also allow households to purchase those big ticket items that can make life be a little more enjoyable. The unfortunate fact of a credit card, however, is that unless a purchase is paid off before a grace period or introductory interest rate period expires, then interest is going to be paid on that purchase, making it cost more than the retail prices at the register.

Here Are the Terms You Need to Know

Introductory Period: Interest rates are artificially lower for users when a new account is opened or an existing credit card is modified. A 0% APR is a common introductory offer.

Grace Period: This is the amount of time that a purchase sits on a line of credit without being subject to interest. Most grace periods are 21-28 days.

How Much Will That Item Actually Cost?

Let’s say that you’ve got a credit card with a $2,000 line of credit. Let’s also say, for the sake of math, that you’ve decided to purchase an item that has a total cost of $1,000. Under current US law, this means that your minimum monthly payment for that purchase is going to be $40. It doesn’t matter what the interest rates on the credit card happen to be in this circumstance.

The actual interest rate of the credit card will, however, affect how much money one would pay if the minimum monthly payment was made every month on time. Here’s a breakdown of what some common interest rate levels would be and how much interest would be paid on that $1,000 purchase [assuming no additional purchases were made].

  • With a 10% APR: A total finance charge of $126 would be achieved, making the total purchase be $1,126.
  • With a 15% APR: A total finance charge of $207 would be achieved, making the total purchase be $1,207.
  • With a 25% APR: A total finance charge of $427 would be achieved, making the total purchase be $1,427.

As you can see, it pays to pay more than the minimum amount that is due every month. With a high interest rate card, just a few extra dollars toward the balance due every month could result in a savings of a couple hundred dollars easily.

The Length of Time to Pay Off the Debt Is Also Affected

If you’re paying just the minimum amount due on a credit card, then you’re extending the amount of monthly payments that need to be made. This is especially true if interest rates are above 20%. In the scenario above on the $1,000 purchase, the credit card holder with a 10% APR would have to make $40 payments for 29 months to get out of debt. The 25% APR credit card holder? They’d need to make 36 on-time payments to get out of debt.

All credit cards have something called a credit limit. This limit is the maximum amount of money you are allowed to charge on your credit card before you are restricted from any further purchases. The more money you spend on your credit card, the more interest you will have to pay to the credit card company. This will increase the amount of your monthly premium and the overall balance that you will have to pay back on your credit card. So you must always choose an appropriate limit and spend the money wisely.

Limit Approval

The amount of the credit card limit will depend on a variety of factors. When you first apply for a credit card you will be asked how much credit, or spending power, that you want to have on it. After you submit your application with the requested amount, the representatives of the credit card company will review your application and personal financial history to determine if you are eligible to receive the limit you wanted. Since you will be providing them with your social security number on your application, they will use that to conduct a credit check on you.

This credit check will be one of the deciding factors in what your credit limit will be on your new credit card. If your credit history shows a good track record of making payments on other credit cards or loans, then the credit card company will trust you enough to issue you a higher limit. However, if you have a history of not making payments and defaulting on loans, then the credit card company will lower your limit. Either that or they will flat out reject your application and not issue you any credit card.

Choosing a Limit

If you have good credit then you should still be responsible when choosing a credit limit. Don’t just go out and get a $30,000 limit if you don’t have the income to make the monthly payments on it. Instead you need to consider why you need the credit card and what you will be using the money for.

The best course of action is this: pay off your credit card within the grace period. Don’t allow outstanding balances to remain when an introductory period expires. If you must have a balance on your credit card, then pay off as much of it as you can every month until you are able to get out of debt.

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Christopher - BSc, MBA

With over two decades of combined Big 5 Banking and Agency experience, Christopher launched Underbanked® to cut through the noise and complexity of financial information. Christopher has an MBA degree from McMaster University and BSc. from Western University in Canada.