Credit Card Interest And Why You Should Always Pay Your Balance in Full

ByThe Miles Professor

I have said numerous times and I’ll continue to say it. If you’re going to get involved with any kind of rewards credit cards, you should always make sure you pay your balance in full every month. If you do not, you will be charged interest and interest rates on most of these cards tend to be extremely high. When earning miles, the first concern should always be financial – making sure you’re not in a position where you’re carrying a balance. Earning rewards should be secondary or, at best, a far later concern than not carrying a balance. The interest rates you pay will quickly offset all the earned rewards and then some.

In this post, I want to point out two facts about how interest rate works and why it may end up being even higher than you think. For simplicity of numbers, let’s take as an example a credit card that has an APR of 24%. Just for simplicity. It may seem like a high number, but it’s definitely not atypical.

What Interest Rate Are You Actually Charged?

The first part to understand is that you’re not just charged the APR rate on your credit card. Interest is frequently compounded daily. Interest being compounded means that you’re being charged interest on the interest you owe and, in finance, we frequently say “nothing grows as fast as compounded interest”.

If you’re being charged 24% on your daily balance, you’re actually being charged (1 + 0.24/365)^365 – 1 = 27.11% over the course of the year. After two years, you’ll be charged 61.5%. In addition, not only will your interest be charged daily, but your balance will be recomputed daily (which I explain in the next section).

You can see that, year after year, the amount owed will continue to grow exponentially if you leave things unpaid. Making a big purchase on a high interest credit card and making the minimum payment for years is one of the most dangerous financial moves you can make.

You Are Not Just Charged Interest On The Unpaid Balance

Although different banks have different rules, here’s an example of of how interest rate work with a few banks when you haven’t paid your balance in full: In any given month, you are not just charged interest on your unpaid balance. You are charged interest on your average daily balance until everything is paid in full and this could lead to far higher charges than you’d expect.

Let’s take a look at an example. Say one month you pay off your entire balance except $100.  $100 isn’t that much and, if you’re charged 2% a month, the interest penalty should be $2. An inconsequential amount. Suppose now that the day after your statement closes, you charge another $10,000 and don’t pay it until that statement closes. Your average daily balance is now $10,100. You’re being charged 2% of the $10,100 and that’s now $202 in interest you owe and that’s despite only leaving $100 in unpaid balance.

Summary

Think twice about getting involved with any rewards credit cards if you may leave balances unpaid. Any kind of financial situations should be taken care of first and vacation planning second.  When I talk about credit cards in my posts, I expect everyone to be aware how dangerous unpaid balances are and to keep this in mind… but it never hurts to remind everyone. There are big rewards when you do it right, but there are also big downsides if you’re not in the right position in terms of credit cards.

10 Comments

    1. You won’t be charged for the intro period, but the danger with that is you need to make sure to suddenly pay the full bill before the intro period expires. It’s really best not to rely on 0% interest anyhow for an period of time. Those who are unable to pay the balance during the 0% APR period are likely stretching their finances and will be unable to pay it before the interest rate goes up either, succumbing to a high interest rate. So it’s best to just always pay it.

      In terms of credit score, it is better to have a lower credit utilization ratio – that is, if you use a smaller percentage of the credit you have available, this impacts your credit score positively. Another reason to always pay it – and I even usually pay before the statement closes.

      1. Let me tell you a bit about myself. I have a bunch of cards and always pay in full. My total limit is close to 6 figure.

        I have been thinking of getting a 0 intro apr and move other CLs to that card, take the money and invest! Just wanted to know if this can potentially hurt my score.

        1. One of the components of your credit score is your credit utilization ratio, which is basically how much of your extended credit you are using. If you are using a high percentage, it makes it appear you have more debt and are stretching your limits and your score is lowered accordingly. Many advise trying to keep it well below 10 or 20% for that reason. Another issue with using 0% APR borrowed credit is that an investment may or may not go the way you planned and then you still have to pay back the full amount. The last consideration is that 0% APR is typically short term and, if you’re investing with those short term funds, you’d have to take on strategies with more of a short term payoff horizon, which may or may not be more risky. You should do what you’re comfortable with and this is by no means any kind of investment advice, but just a few things to consider :)

  2. One thing to be aware of also is the 0% balance transfer offers I’ve been seeing lately. Normally there is a grace period of 20-25 days after your monthly statement ends where you can pay off the full balance without accruing any interest. Well, this grace period is usually waived for regular purchases if you take advantage of these balance transfer offers. This means if you made a balance transfer on day 1 and then make a regular purchase on day 2, you’ll be paying the APR for that regular purchase every day moving forward until you pay it off.

  4. So if someone buys a big screen TV planning to pay it off in a course of a year. How would it prevent him earning points on a credit card that he uses to buy groceries for example? Or you recommend not to use credit at all? How about mortgage or student loan?

    2. Don’t buy the big screen TV if you need a year to pay it off – that means you can’t afford it.

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