Twenty years ago when Michael Riley first released his Credit Card Math tutorial, most people had no clue how interest on credit cards work. In fact, his revelations about how credit card interest and payment methods worked were considered so shocking that they ended up being featured in a national news program’s investigative report.
Fast forward to today, and a proliferation of tools such as free online credit card calculators are widely available (here’s a credit card payoff calculator, for example). No question, they’ve helped. But guess what? The math credit card issuers use can still be confusing.
“It is never really easy to figure it out,” says Riley.
Take a $2,100 credit card balance at 17.9%. At the typical monthly payment required by card issuers, $53, it takes more than 15 years to pay off, explains Riley in the recently updated version of Credit Card Math. But if card issuers used the same methods that banks use to calculate interest and payments for auto loans, you would cut that time by a third. It would take just five years plus one month to pay off.
Riley says that consumers today still make mistakes when it comes to paying off debt faster and in the most efficient way. Here are three ways basic math trips up credit card users.
1. Miscalculating Interest
One of the fundamental differences between the way interest on credit cards is calculated versus the way it is calculated on other types of consumer loans is that card issuers use the “average daily balance” method to calculate interest. With the average daily balance method, the issuer adds balances from each day of the billing cycle to get a total which is then divided by the number of days in the billing cycle to get the average. Interest is charged on that average daily balance.
If I lost you already, don’t worry. Here’s what it means in practical terms. Let’s say your balance is $500 and you plan to pay $300 of it. You figure you will only pay interest on the remaining $200 you owe after your payment is applied. But depending on when your payment arrives, and if you make additional purchases, you may be charged interest on the higher average daily balance for the billing period.
Here’s a tip: The sooner you pay, the faster you reduce your average daily balance and the interest you will be charged on it. So even if you just make minimum payments, don’t wait until the due date. Make your payments as soon as you can.
2. Trusting the Statement
If all you did was make fixed monthly payments on your credit cards each month – Riley calls them “constant payments” – you would pay off your credit card debt much faster. And in fact, thanks to the Credit CARD Act, statements now list the payment you need to make to pay off your debt in three years at the current balance and interest rate. But that disclosure on statements can be somewhat misleading. That’s because as you pay down your balance, the next statement will show a new three-year repayment time period based on the lower balance. As your balance continues to decline, the three-year payment amount drops and the payoff date is pushed further and further into the future.
Another tip: For constant payments to work, you need to pick an amount that you’ll pay this month and pay that amount every month until the debt is paid off. Of course, you can’t add to your balance with new purchases, either, or you’ll mess up the math.
3. Scattering Your Focus
Another major mistake consumers make: They take a shotgun approach to paying off multiple balances when they should be laser-focused.
If you carry balances on multiple cards, it gets even harder to come up with a strategy. “If people have extra money,” say Riley, “they will divide it up and put a little toward all their cards.” But unless your interest rates are the same on all your balances, that approach won’t maximize your savings. Instead, target one debt at a time. Pick the one with the highest interest rate and pay as much as you can toward that one until it is paid off. Then, move onto the next one.
He gives an example of someone with an auto loan and five credit cards at interest rates ranging from 12.9% to 21.9%. Making minimum payments, it would take that borrower just shy of 12.5 years to pay them all off and cost nearly $5,000 in interest. But by strategically paying just $100 more each month to the highest-rate debt, and keeping the total monthly payment on all debt constant, that same person can pay off those same debts in just under two years, and save $3,318 in interest.
Final tip: If you really want to get out of debt as fast as possible, target your highest interest rate debt first. Pay extra toward it, and when it’s paid off, take the amount you were paying toward it and apply that to the card with the next highest rate and so on. You’ll create a “snowball” effect that’s unbeatable in terms of saving time and money.
Of course, the lower your interest rates, the faster you’ll pay off your balances. The best interest rates go to consumers with strong credit scores, so review yours. You can get two free credit scores and an action plan for your credit at Credit.com. Then consider a lower rate consolidation loan to save even more money. But if you can’t qualify for a lower rate, you can still get out of debt faster by strategically making payments. Just do the math.
This article originally appeared on Credit.com.
Gerri Detweiler is Credit.com's Director of Consumer Education. She focuses on helping people understand their credit and debt, and writes about those issues, as well as financial legislation, budgeting, debt recovery and savings strategies. She is also the co-author of Debt Collection Answers: How to Use Debt Collection Laws to Protect Your Rights, and Reduce Stress: Real-Life Solutions for Solving Your Credit Crisis as well as host of TalkCreditRadio.com. More by Gerri Detweiler