Understanding credit cards: Their purpose, positives, and potential pitfalls

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Credit cards. They’re the go-to choice for millions of consumer purchases, but we also have a love/hate relationship with them. Credit cards can be a tool that helps you stay on top of your money, but they also come with a downside—particularly high interest rate charges if you carry a balance.

Here’s what you need to know about credit cards, how they work, and how to avoid getting sucked into a debt trap.

Basically, a credit card is a short-term loan. The credit card issuer is letting you borrow money, up to a certain limit. If you don’t pay back the full amount within a set period of time, the issuer will charge interest on the remaining balance.

Credit cards represent what’s known as revolving credit. The issuer tells you the maximum amount you can borrow. For example:

As you pay down your credit card balance, you “free up” more room to spend. But how does it all work? And how did they come up with that interest charge?

Here’s a breakdown.

The first important concept to understand is credit card interest. Credit cards typically operate on a monthly billing cycle. At the end of each cycle, there’s a grace period of a few weeks before the “due date.” If you pay off the full balance by the due date, you’re typically assessed zero interest charges.

But if you don’t (or can’t) pay off the full balance, you’ll be charged interest.

How much you pay in interest depends on two things:

There are a couple of ways to figure out how much interest you’re being charged on a balance. The easiest is to base it on a monthly charge. If your APR is 22.99%, your monthly interest rate is approximately 1.92%. At the end of the month, if the balance on your credit card is $800, you can multiply that amount by 0.0192 to find that you will pay about $15.33 in interest.

Many credit cards charge daily interest, which is where things can start to get interesting. First, divide the APR by 365 to get your daily interest rate. For our example, that means 22.99 ÷ 365 = 0.06299%.

Here’s the good news: If you pay off your balance before the end of the monthly billing cycle, none of this interest gets added to your balance and it isn’t charged to you. But if you don’t pay off, it all gets tacked on to what you owe.

You can see how this interest could add up over time, even though the amounts seem small on a daily basis. In our example, if you just stuck with the $900 balance and were charged 57 cents a day, at the end of a 30-day billing cycle, you’d be paying $17.10 in interest. With a higher APR and a higher carried balance, this could quickly become overwhelming.

That’s the power of compounding. On money you earn, compounding acts as a turbo-charger. But when you’re paying interest, compounding adds to the pain.

To understand credit cards, you also need to understand how the payments work.

Many card issuers offer a minimum payment, which is the smallest amount that’s still considered a “full” payment. But if you only pay the minimum, it can take much longer to get rid of credit card debt. Many card issuers set the minimum payment at somewhere between 3% and 5% of your balance. If you have a high APR, your minimum payment might barely cover your interest.

Suppose your credit card balance is $1,000 with a 27.99% APR. For simplicity, we’ll base this on a monthly interest calculation. Your credit card issuer figures a minimum payment based on 3% of your balance.

If you only pay the minimum payment—even if you never charge another dime—it will take you five years and seven months to pay off the original $1,000 and cost you about $986 in interest. This accrual of interest charges is why it’s so important to pay off what you spend each month—or at least pay as much as you can.

Finally, don’t forget about credit card fees. Depending on the card, some of the fees might include:

All of these fees can be added to your balance—and interest will be charged on the total. Before you get a credit card, find out what fees might be charged and how they affect the overall cost of borrowing.

Credit cards can smooth your finances and even help you earn rewards and cash back. But they also have a downside. You can easily get into debt and find yourself paying a hefty price in the form of interest and fees.

Before you get a credit card, make sure you set a budget and that you understand credit cards and how they work. Spend only what you’ve planned, and try your best to pay off the credit card each month to avoid accruing interest.

How to Calculate Credit Card APR Charges | chase.com