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(Excerpted from Stop Getting Ripped Off) Chew on this: A credit card with an $8,000 balance will suck more money out of your wallet every month than $45,000 in student loan debt. Don’t believe me? That’s credit card math for you. I’ll prove it later in this book. For now, I want you to keep in mind how devastating credit cards can be to anyone’s financial life. Think of then as the Trojan horse in your wallet. They are wrapped up like gifts from banks, but when their full army of hidden fees and finance charges are unleashed, the attack can be hard to withstand. This is a very exciting time for credit card users, however. The industry that never met a fee it didn’t love finally killed its golden goose, and during the 2008-2009 recession credit cards became a lightning rod for anti-bank sentiment. Much of the populist anger over the bailout was aimed right at card-issuer misbehavior. First the Federal Reserve, then later Congress passes rules that banned many of the most egregious behaviors . Starting in 2010, these blatantly unfair tactics are now verboten Universal default – raising a customers interst rate because an unrelated bill was paid late Two-cycle billing – a math trick that often doubled the appropriate finance charge Retroactive interest hikes – The practice of applying new rate hikes to past balances. There are exceptions where this awful practice is still allowed, however. Automatic over-limit fees – customers must now agree in advance to over-limit fees Don’t feel bad for Capital One, American Express, MBNA, and all the other card issuers however (I know you don’t). Even while the ink was drying on President Barack Obama’s signature on Credit Card Accountability Responsibility and Disclosure Act, card company mathematicians were hard at work inventing new tricks and traps. Here’s one of my favorites: It’s now possible to be charged a foreign transaction fee without even leaving the United States. You online shoppers, listen up. Foreign travelers have known for years that they are subject to a 3 percent fee for every transaction that’s performed in a foreign country. Starting in the middle of 2009, banks began charging foreign fees to U.S. consumers who shopped stateside – say, on the Web – but purchased from companies based elsewhere. The most obvious example is airline tickets purchased online from firms like Ryan Air or Air Malta. The Web is worldwide, you know. And it’s easy for shoppers to click around and not realize they’re buying from an overseas firm. No matter: Bank of America can take 2 percent of each purchase, and Visa an additional 1 percent. As card issuers continue to digest the new rules, expect such new fees to pop up everywhere. When trying to regulate the industry, Congress is playing a game of whack-a-mole. Beating back one unfair fee does nothing to stop a new one. That’s why this chapter will say much more about how credit cards and credit card math can be used to your advantage. There will always be creative financing by banks. The very design of credit cards is meant to confuse you and make you pay extra for everything you do. But it doesn’t have to be that way. Once you’ve mastered the plastic, you can start mastering your financial future. But first, you must understand the rules of the game as they’ve been set against you. So let’s get right to it.
*** When it comes to credit cards, there are three kinds of users: those who pay their bills in full on time every month; those who occasionally run a balance and pay interest; and those who never pay their balance in full, and are playing Russian Roulette as “revolvers “. The advice each group needs is very different, so at the end of this chapter, you’ll finds tips by type of card user. But first there are some important tricks you need to know, no matter what kind of card holder you are. Even if you pay your bills on time almost every month, these tricks could be costing you hundreds of dollars each year. Everyone needs to understand credit card math. Even if you are the ultimate responsible card user, some day, your number will come up. When it does, you’ll slip down the rabbit hole into credit card Wonderland, and you’ll need to act fact and minimize the damages. How crazy is this Wonderland? You responsible card holders out there very likely hold too few credit cards. While the proper number of cards remains an industry secret guarded more carefully than the Colonel’s fried chicken recipe, you need to know that the habit you’ve formed of keeping most of your charges on a single card with a single bank is a bad habit – at least in our twisted world of credit scores. The higher a balance you keep, the more money you borrow from credit card companies, the bigger the mistake. As the years pass, we are learning more and more about the secret sauce which is used to generate the three-digit number that dictates your financial prospects in America. We still don’t know everything. But thanks to the fine work of people like John Ulzheimer, who once worked at Fair Issac, the keepers of the credit score secret formula, we know quite a bit. Ulzheimer wrote a book called You’re Nothing But a Number, and also runs a site called Credit.com. Here’s he preaches: “credit utilization” is an incredibly important factor in your score. Let’s say you have only one credit card, and that card has a $3,000 limit. Now, let’s say you spend a lot on your card each month, maybe $2,000 in personal and work expenses, perhaps in a quest to earn “valuable” rewards points. And you carefully pay it off in full each month by the due date to avoid any finance charges. That’s bad. Very bad. It means you often use almost all the credit you have, and the credit score people think that means you are likely to begin defaulting on your loans. I fact, you could be killing your credit score. Depending on what time of the month your score gets pulled, near-the-limit utilization could knock 30, 40, or even 50 points off your score. To counter this effect, Ulzheimer recommends….get this…never using more than 10 percent of your credit limit. That means never running a balance higher than $300 on that $3,000 limit card. That’s something you won’t find even if you read every last sentence of your cardholder agreement. You remember, that’s the leaflet with 8-point “mouseprint” that’s tucked into your monthly bill once a year enumeration all your rights. From the perspective of your credit score, you are better off spreading your charges among multiple cards. That, of course, is how many people end up in serious credit card trouble, and one of the many ways that the credit industry pushes consumers in impossible and contradictory directions. I don’t recommend you use 5 or 6 cards, because even the most responsible consumer will eventually screw up and miss a payment when their finances are spread so thin. But I do recommend you always have at least one card that is spotless, which can be used during those emergency months when you might run a balance that approaches half of your available limit. And I recommend paying special attention to credit utilization during the two or three months before you make a major purchase that will involve a loan, like a car or a house. If need be, spread your charges among two or three cards to keep your utilization low. On average, Americans don’t overuse credit cards Now before I get to credit card math and other crappy things banks do, I want to speak a bit more to the credit puritans. I know there are plenty of holier-than-thou card users who never run a balance, and they think the rest of the population is stupid and greedy. They snicker when they hear data points like this: The average American family has $8,000 in credit card debt. We should snicker at those numbers, which are included in every story that lampoons credit card consumers – because they represent the fact that journalists are bad at math. And as we learned in the introduction, so is the self-satisfied crowd. When financial reporters insult indebted cardholders, they are indulging in the classic mean/median/average mistake. Let me illustrate. Take 10 cardholders: 9 have $1,000 in debt, and the 10th has $11,000 in debt. What’s their average debt? It’s $2,000 ($20,000/10). What is their median debt? It’s $1,000. Which is the more “accurate” indication of typical debt? Now, to exaggerate my point. Take 10 cardholders: 9 have $100 in debt, and 1 has $99,100 in debt. What’s the average debt? It’s $10,000. Write that in a story, however, and you are unfairly besmirching the 9 centurions. But that’s what you normally get in stories about credit card debt. Here’s a much more accurate picture of America’s addiction to credit. Nearly half of all Americans run a balance each month. That’s bad. But the more important number is this: only about one in 20 Americans carry a balance of more than $8,000 each month. The extreme cases of $50,000 debts drown out the truth of the matter – half of U.S. households owe $2,200 or less to credit card companies, and in fact, many owe nothing. So those of you who like to think that America is dominated by families who outfit their living rooms with the latest technology using plastic to spend money they don’t have – you’re wrong. Yes, there are many of them. But they are a small minority. I thank personal finance writer Liz Weston for her public haranguing of this misunderstanding. I stress this point because I hear many irritating holier-than-thou things from pro-industry consumers who write in to my Red Tape Chronicles blog. The most irritating are those who argue that people who get hit with hidden fees from banks deserve them. “They should learn to manage their money!“ is the constant theme. Meanwhile, the exaggerated myth of the hyper-consuming American is used as justification for egregious bank behavior. Financial institutions regularly perpetuate this myth to distract people from these unfair tactics. There’s a serious logic problem here, and to dispute it I’d like to invoke the wisdom of kindergarten teachers everywhere: two wrongs don’t make a right. Excessive consumption is not justification for predatory lending. Average daily balance – and the pay early, buy later strategy I’m sure by now you are well aware of the basic principle at play. Banks hire mathematicians who spend a lot of time trying to cook up formulas that are extremely advantageous to them. Every last tenth of a percentage point means a lot to banks. It might not sound like a lot to you, but it adds up to millions of dollars for the bank. Remember the plot of the movie Office Space, which involved a scheme by a computer programmer to skim off fractional percentages of pennies from thousands of payments? When an employee does that, it’s called stealing. Oddly, when a bank does that to consumers, it’s called a business plan. You might be inclined to just roll your eyes at all this, throw up your hands, and pay up. But you don’t have to. Knowledge is power. Adjusting your payment strategy to account for bank mathematics can save you a lot of money, whether you run a balance all the time, or almost never. But you have to know the rules first. And the most important rule is the “average daily balance.” Human nature dictates that people pay their bills at the last possible moment. On the other hand, people spend money erratically during the month. Some months, you might evenly spend $200 each week on charges. But the next month, perhaps you go on vacation and spend $2,500 during the last week. If you are a bank, how can you make sure to maximize the interest you charge on all these purchases, accounting for the fact that people pay bills at the end of the month? More importantly, if you’re a consumer, how can you reverse that effect? The essential point of understanding is the way card companies calculate interest charges. The method is called “average daily balance.” The bank takes the average of your outstanding balance each day during the current billing cycle (or during two billing cycles, as we explained above), then applies a daily interest rate to it. Here’s a basic example. We’ll start off with very simple presumptions to show clearly how bad the effects are. Later, we’ll use more realistic, real life examples. Say you make a single $3,000 purchase for plane tickets in a month during which you have no grace period because you are carrying a balance. To make life easy for now, we’ll say that balance is one penny. If the purchase is made five days before the end of a 31-day month, at a rate of 29 percent, interest charges will be $11.92. But if you make the charge 5 days into the month, the interest charge is more than *five time higher* at $64.36. Putting off big-ticket purchases for 20 days can cut your interest charges by 80 percent! You’ll never see that explained in those pre-approved offers you receive in the mail. Don’t believe me? Let me explain. Take the first example: For the first four days of the month, your balance would be zero. Starting on day 5, your balance is $3,000. After 31 days, your average balance is $2,612.90. Multiply by the daily interest rate of about 8 cents per day per $100 and you arrive at $64.36. Now, the second example: Your balance is zero until day 27, when it rises to $3,000. After 31 days, the average daily balance is $483.87. Multiply by the daily interest rate of about 8 cents per day per $100 and you arrive at $11.92 Confused? Here it is in chart form:
COURTESY: NCNBlog.com
Now you see the perils of the average daily balance. Perhaps you don’t think very much about these fractional interest charges when you buy things during the month, but the bank sure does. And the penalty for not thinking like a bank is severe. Now, let’s start filling in the spreadsheet a little bit to make it more realistic. It’s much more likely if you’re paying interest that you’ll start the month with a balance, you’ll make a series of purchases during the month, and you’ll make a payment. Let’s flesh out the picture and see how the average daily balance could really be hurting you. If you start the month with a $2,000 balance – all other things remaining the same from above – your finance charges will rise from $61.18 to $113.62 if you buy those plane tickets at the beginning of the month instead of the end.
Now, let’s add a payment. Say you pay $1,000 toward your balance that month. If you pay in the middle of the month, on the 15th day, and buy your ticket toward the end of the month, your interest charges will be $47.67. But if, like most people, you pay at the end of the month, and buy your ticket early, your finance charge will be $112.82. Notice, a slight adjustments to your buying and paying habits, in this example, can cut interest charges by nearly two-thirds!
Finally, let’s look at the most realist example. I’ll randomly sprinkle $300 worth of charges throughout the month – evenly through both examples. While this mutes the impact I’ve described *slightly*, it’s still quite apparent. Making the large purchase early in the month and the payment late in the month carries with it a staggering 225 percent penalty!
Clearly, there are times when consumers cannot control the timing of purchases – emergency auto repairs, for example. Delaying plane ticket purchases can carry other financial risks – namely, the price may go up. Real life can intrude on this example in many ways. But that’s not my point. My point is: banks use this spreadsheet, and you don’t. Banks write the formulas and do a terrible job of explaining their impact on you. Spreading interest rate charges over the maximum amount of days is a clever way to increase bank revenue. Making slightly smarter choices about when you buy things and when you pay for things can save you a whole lot of money. Your most important takeaway from this discussion is: time matters. When you buy things matters, and when you send payment matters. For example, Don’t wait until you receive the bill to make payment! Sending payments two weeks early every month would save you $150 a year. CLEAN CARD STRATEGY Naturally, you can’t always control when you make credit card purchases and payments. If you could, you wouldn’t be using credit cards in the first place. If you are like 50 percent of Americans, you run a balance each month. And if you are like 99 percent of Americans, when you run a balance, you keep using that credit card, keep wracking up interest charges, and pay up thinking there isn’t much you can do to pay less. Well, there’s a lot you can do – you can use the clean-card strategy. Put simply, you should always have one “clean” credit card in your wallet or purse; a card that you know you can pay off in full every month. Here’s why. Recall the “fall from grace” that occurs the moment you don’t pay your credit card bill in full on time. The lure of credit cards is the free 30-day loan you get when you buy something with plastic. As long as you pay up by the due date, you pay no interest charges. This is called the “grace period.” But the first time you are late, the grim reaper appears. Interest charges now accrue immediately on all future purchases. Roughly speaking, you pay $1 per day for every $1,000 you borrow with a high-rate credit card, or about $30 per month and $360 per year(based on about a 32 percent interest rate). Scenario 1: You have a card with a $100 balance and a second, “clean” card. You make a $1,000 purchase on the first day of the month and pay the card off 30 days later. Interest charges; Card 1=$2 Card 2=$0 Scenario 2: You have a small balance on your credit card. You make a $1,000 purchase on the first day of the month and pay off the entire card on the last day of the month. Interest charge=$27. That’s nearly a $30 difference! Now, spread that impact out for an entire year, and compound it, and you’ll hit about $360. Once again, I’ve oversimplified the math to show the impact, so let me make the scenarios a little more realistic. In this case, however, you’ll see how the clean card strategy can save you even more than the pay-early, buy late strategy. What I really want you to do if have two credit cards that you use in very different ways. Card one is a *charge card.* You make all your work-a-day purchases with this card. You vow to whatever God you believe in that you will pay off this card in full every month on time. To make sure you do that, you sign up for electronic bill pay at your bank and send a check to the credit card firm automatically every month five days before the due date. You make the payment for your average budgeted amount; you can always manually adjust the amount. Card two is a line of credit card. You pull it out for big, emergency purposes that you can’t pay off in full within 30 days. Then you put it back in your wallet, purse, or holster, with the safety latch on. This will have two important effects on your credit card spending. One immediate improvement: you will have a much better grasp on your debt. Revolving debt, where you are constantly adding and subtracting to the total, tends to get murky for users. And when things get murky, your financial brain checks out and gives up. When you are a serial revolving credit user, you lose track of what you owe, and more important, you lose grasp of when you will pay it off. A single credit card with a $3,500 balance that never grows is manageable. You know that paying about $100 a month, you’ll pay it off in about three years. On the other hand, a card with a $3,500 which is used to make $300 in purchases this month, then $50 next month, then $254 the following month, while you make $125 payments each month, except last month when you only paid $75…well, I’m not going to tell you how long it will take to pay that off. I want you stop living like that. Dividing your purchases up into “charge cards” and “line of credit” cards will help you get your head around your debt and your financial situation.
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