Credit Card Interest Rate – Why You May Be Suffering Because of It

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The consequences of not paying your credit card bills in full is huge and can possibly lead to bankruptcy for those who are not disciplined enough.

One of the reasons why many people seem to be playing catch up with their ever increasing debt is the lack of awareness and education. To safeguard yourself from falling into the debt trap, it is important to find out and understand how card issuers calculate financial charges (i.e. interest) based on your outstanding credit card balance.

How to calculate monthly flat rate interest?

To understand why interest is such a threat to your pocket, let’s take a look at how normal monthly interest is calculated using a flat rate. This is really simple and can be done with just a calculator:

Monthly interest using flat rate = (Annual Interest Rate (%) X Principle Amount) ÷ 12

Example: If you owe RM10,000 and the rate is 18% p.a., your monthly interest would be (18% X 10,000) ÷ 12 = RM150

How is your interest computed?

Credit card interest is calculated based on compounding interest every single day. To understand how it works, consider this:

Day one: You start off with a principle amount. By the end of the day, your daily interest is computed based on this principle amount using a daily rate (basically, by dividing your annual interest rate by 365 days). Then, this interest is added onto your principle amount.

Day two: You now start off with a higher amount compared to the day before. At the end of the second day, your interest is computed again for the day but this time based on your new, higher principle amount.

Day three and beyond: The same computation occurs like in the second day and continues perpetually until you cleared your account.

Example: If you owe RM10,000 and the rate is 18% p.a., your monthly interest would be roughly RM154, that’s RM4 more than if you were charged based on a flat rate! Due to the compounding effect, the actual interest rate you’re being charged (also known as “effective interest rate”) is roughly 19.7% p.a. and not 18% p.a.!

What does this all mean?

As a smart consumer, it is imperative that you do not plan your cash flow based on the advertised rate, simply because that’s not how the numbers work.

The supremely high rate aside (i.e. imagine how happy we’d all be if our fixed deposits are paying us, say, 18% per year!), the compounding calculation method that these card companies adopt all add up to make this credit facility a very dangerous financial instrument for the undisciplined.

The key takeaway here is to pay as much as you can (instead of as little as you can, which is what many people are doing) on your bills. After all, it simply doesn’t make sense to subject yourself to obscene amount of financial charges – which is exactly what you’ll be doing every single day as long as you have unpaid balance on your account.