Financial Literacy: Understanding Credit Cards

By: Beenish Khurshid, San Francisco, California

Credit cards are a fundamental part of modern life. But what is a credit card, and how does it work?

A credit card is a line of credit - an agreement between you and a bank or financial service - the lender. You can use a credit card to make payments, purchases, and take out cash, and pay back your lender at a later date. This all sounds great, but credit cards can be tricky, and if not used right, they can lead us to a precarious financial situation.

CREDIT CARD BASICS:

CREDIT LIMIT - this is the maximum the lender is ever willing to lend you.

BALANCE - this is how much you owe the lender at any given time.

CLOSING DATE - this is the date on which your balance is due. If you do not pay the full balance by this date, interest will be charged on any remaining amount.

STATEMENT - A monthly document either sent to you in the mail or in a digital statement in your lender’s website outlining your purchases and spending that month, the interest rate, balance due, and due date.

INTEREST RATE OR APR- This is the percentage that will be charged on the balance remaining after the closing date. How interest is charged is a bit complicated. Let’s say that your balance on your statement was $6000, but you were only able to pay back $1000 by the closing date. This means you still owe $5000. Every day you don’t pay your balance off, you are charged interest.

Say your credit card agreement says your interest rate is 30% APR (APR means annual percentage rate). This means your daily interest rate is 30%/365 (365 days in a year), which is about 0.082%. Credit cards also use a concept called compound interest. This means, for every day you don’t make a payment, interest is charged on yesterday’s balance including interest. This means, you pay interest on the interest you owe. Confusing right?

Let’s do the math. Say it takes you another 15 days to pay off your balance. Every day after the closing date, you will owe a bit more than your last day - based on how much you owed yesterday.

Like, if your balance at Day-0, or closing date is $5000, and your daily interest is $0; on day-1 your balance will be $5004.11, the interest you will be paying is $4.11. The next day or Day-2 the balance will be $5008.22, and the additional interest you will be paying is $4.11. The following day, on day-3, the balance you owe will become $5012.33 with an additional interest of $4.12 .

Let’s keep applying the daily interest rate and see what happens by Day 15.

So, at Day-13 your balance will rise from $5000 to 5049.53 with daily interest of $4.15. On day-13 it would become $5053.68 and day-14 the balance will become $5057.83 and on day-15 you will owe the amount $5061.99 to your lender on the daily interest of $4.12.

So by Day 15, you owe $61.99 extra, on top of your $5000 original amount owed, a steep cost to pay in such a short amount of time!

CASH ADVANCE - A cash advance is when you use your credit card to take out cash. You can request a cash advance at a store teller, or at an ATM. While it may seem like cash advances aren’t much different than using your debit card to take out money from your account, especially if your credit card is bank issued, cash advances are *not* the same as taking a cash withdrawal from your personal account.

Compound interest is charged on cash advances - usually the same interest rate as purchases or higher. In addition, interest is charged starting the *day* of the cash advance, not starting the due date.

HERE IS AN EXAMPLE. Let’s say you have a checking account with Bank of the Great. Say you have $5000 in your account. This account comes with a debit card. Let’s also say you have a credit card with Bank of the Great, with a $6000 credit limit, and a 30% interest rate.

Let’s say you go to the ATM, and instead of using your debit card, you accidentally use your credit card to withdraw $500 - to buy a second hand phone. It takes you till

Daily interest rate = 0.30 / 365 = 0.00082 90 Day interest rate = (1 + daily interest rate) ^ 30 - 1 = 0.025 Interest owed at day 90 = $12.48 Total Balance = $512.48

MINIMUM PAYMENT - this is the minimum amount you have to pay per month to stay in good standing with your lender

SPIRALLING DEBT - when your monthly payments don’t cover the interest charged, your debt can quickly spiral uncontrollably.

HERE IS AN EXAMPLE.

Let’s say you start off with a $6000 balance on your credit card. The credit card’s interest rate is 24% APR, and you put $100 towards it every month.

If the card didn’t charge any interest (0%APR), you would be able to pay off the card in 5 years ($6000/$100 = 60 months). But since the interest rate is 20% APR, you’ll see how this debt spirals out of control quickly.

Monthly interest rate: 1.991526%

If you have a balance of $6000 at the start of the month, by the next month or Month-1 the balance will be$6019.49 with $100 minimum payment. The added interest will be $119.49. Inmonth-2 you will owe $6039.65 with $100 as monthly payment the added interest will be 139.37. This same amount will look like $ 6059.65 by month-3 with same$100 minimum payment, the added interest you owe will be $159.65.

As you can see, the monthly payments are not keeping up with the interest added every month.

Let’s see what this looks like over 5 years

If your starting balance in year-0 was $6000, your time to pay it off if 0% APR was 5years. In year -2 this will become$6256.31and your time to pay it off will increase to 5 years and 3 months despite paying $1200/ year. The year-2 balance owed will become $6555.48 and the time to pay off will increase to 5 years and 6 months and the interest added will be $299.17. During year-3 the amount will become $6965.08 the time to payoff will be 5years and 10 months interest added $409.6 despite paying $1200/year.

As you can see, despite putting $1200 per year to a $6000 debt (1/5th of the debt), the debt keeps growing, and the time to pay it off keeps increasing.

RIBA - The Arabic term for interest is Riba. Charging interest is haram in Islam. Here is some of what the Qur’an says about Interest:

“And if someone is in hardship, then [let there be] postponement until [a time of] ease. But if you give [from your right as] charity, then it is better for you, if you only knew.” (2:280)

And whatever you give for interest [i.e., advantage] to increase within the wealth of people will not increase with Allah. But what you give in zakāh, desiring the face [i.e., approval] of Allah - those are the multipliers. (30:39)

Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah. But whoever returns [to dealing in interest or usury] - those are the companions of the Fire; they will abide eternally therein. (2:275)

FINAL NOTE:

Credit card balances can quickly spiral.

Here are a few recommendations:

1.Never use cash advances

2. Always pay your statement balance before the due date

3. Never spend more than you have in your bank account

4. For a better credit score, pay your current balance in full before the statement for the month is issued

If you are in spiralling debt, know that there are ways to get out of debt. Beneficent is one such organization that offers interest free loans for those in high interest debts. (Beneficent.cc)

Beneficent: https://beneficent.cc/

Photo by Ron McClenny on Unsplash