In the last post, The Plastic Money, you read about what credit and debit cards are all about and started dwelling a little bit on credit cards. Taking on from the same example, this post explores on how banks benefit through credit cards – specifically interest rates.
Read the post here!
The Plastic Money
Second Post of the Series – Let’s talk about the F- Word – Finances Psychology suggests that the quickest way to feel in with an individual or a group is to mirror them. You get acquainted with their slang, accent and you are on your way to become accepted. On that note, let me introduce […]
A bank makes money from credit cards and debit cards through commissions, charges and fees. In the case of credit card, there is also a component of interest.
Let us start with understanding how interest is charged on a credit card.
Credit Cards and Interest Rates
If in a world where, everyone pays off their credit card bills regularly, then credit card companies will not be as profitable a venture as it is now.
Did you know the annual interest rate can be as high as 42%?
Yes, the interest rate levied on outstanding credit cards bills is huge.
On an average it is 3.44% per month which is almost 41.29% a year. (Source)
The intention is to ensure people pays their bills on time, and to penalize those who don’t.
How is interest calculated?
General formula to calculate interest on credit card is (Number of days from the date of transaction made x Entire outstanding amount x Interest rate per month x 12 month) / 365
Let us put this into context, and look at a few scenarios.
Continuing the example in the previous blog post
Taking a look at the month of April where you are billed on April 30, and you need to pay the balance by May 20. Your credit limit is INR 10,000.
Paying after due date
In April, you had spent INR 6,000 on April 20 and there was no other transactions
On account of some delays in income, you are not able to pay your statement balance of INR 6,000 by May 20 but you pay it on May 25.
Let us see how much the bank will charge you suppose they levy an interest rate of 3.50%
The interest is charged from April 20 – when the transaction was made to May 25 – when the amount was paid.
The interest for 35 days is INR 241.64 and it is charged to your existing credit limit.
Every passing day becomes expensive by INR 6.90.
The interest is just one part, the bank layers this with late charges and other fees. We will come to that in the next post.
Thumb rule on credit card interest calculation 101
If you have not paid any part of the bill generated on the billing date (here April 30), your interest-free period gets cancelled. You will need to pay interest for the amount from the day you swiped the card.
Do you see the tip of the spiral?
Let’s see how this thumb rule in action.
#1 Partial Payment and no new Transactions
Going back to the same old example.
If you make a partial payment of INR 2,000 on May 22, and the rest of INR 4,000 on May 28, you pay a total interest of INR 243.95
Between April 20 to May 22 (32 days), you pay an interest of INR 220.93
Between May 22 to May 28 (6 days), you pay an interest of INR 23.01
Even if the partial payment was made before May 20, interest will still be charged. Let’s take the same example, and instead of May 22, you pay on May 18, your interest will be INR 234.74
Between April 20 to May 18 (28 days), you pay an interest of INR 193.32
Between May 22 to May 28 (6 days), you pay an interest of INR 41.42
#2 Partial Payment with New Transactions
Now let’s add a transaction for INR 1000 on May 6 – do you think you will be charged an interest for a transaction that happens in the next billing cycle?
Yes!
You are charged an interest on the INR 1000 along with the already existing balance of INR 6000.
If you make a partial payment of INR 2000 on May 22, and the rest of INR 5000 on May 28, you pay a total interest of INR 257.75
Between April 20 to May 6 (16 days), you pay an interest of INR 110.47 on INR 6,000
Between May 7 to May 22 (15 days), you pay an interest of INR 120.82 on INR 7,000
Between May 23 to May 28 (5 days), you pay an interest of INR 28.77 on INR 5,000
In other words, interest is calculated each day on credit limit that you have used.
Minimum Amount
In the same conversation Banks have a minimum amount that can be paid if you cannot pay the entire amount before due date. This is usually 5% of the outstanding amount.
In this case 5% of INR 6,000 which is INR 300.
If you pay INR 300 before the due date, the bank will not charge you late fees and other charges.
Why are we not talking about interest calculation in a debit card?
Any payment you make through a debit card is instantly removed from your account, in other words, from your pocket. Since there is no loan given, there is no question of interest.
However, a debit card, similar to a credit card, attracts other charges and fees
Let’s talk more about the charges and fees in the next post.
If you have any questions, please feel free to DM me, or drop them in the comments below. You can also reach me through my mail ID.
To read the previous posts in this series
And the next set can be read here