Your credit card interest rate doesn't matter

Posted at 10:50 on Thursday June 23, 2005 | Filed Under Saving

Ok, I've gotten some heat for this idea, but I don't care. I'm tired of hearing people bragging about their credit card's low interest rate. Here's why I don't care whether it's 5% or 80%.

What does "interest rate" mean on a credit card?
A credit card basically gives you a short loan for the month. If you pay it off completely during that monthly period, you don't pay for the loan--it's an interest-free loan.

But if you don't pay off the entire balance--let's say you spend $1,000 on your credit card but can only pay off $500 that month--then you have a balance on your card. That's what interest is charged on; typically, it's somewhere around 20%. In this case, you'd be charged $8.33 that month ($500 balance * 20% interest) / (12 months).

Why I don't care if my CC interest rate is 5% or 80%
It's simple: I never carry a balance--and neither should you. If can't pay it off at the end of the month, I don't buy it.

I'm not going to belabor the point because, if you're reading this, you clearly care about your money. But you would be shocked how many people I talk to that charge purchases without knowing how much they'll actually pay for it. So let's take a look...

Let's say you have a $10,000 balance on your credit card and you pay the minimum amount, which is around $250 every month. How much will it actually cost you? The answer is shocking. Get ready!
If you only paid the minimum on your $10,000 balance, it would take you 452 months (over 8 years!) and cost you over $19,000--in interest alone. In other words, you'd pay around $30,000 for a $10,000 balance.

This is why credit card companies are so incredibly profitable, especially with young people who don't know any better.

The point is pretty obvious. Don't carry a balance (if you do, pay it off as quickly as you can). Pay the maximum every time. If you can't pay off a purchase by the end of the month, don't buy it. "But Ramit," people say, "what about homes and college and cars? How can I pay that off in one month?" Yes, true, those very expensive purchases necessitate some kind of longer-term loan. But not with your credit card.

So when I hear people excited about their introductory interest rate ("It's 0% for 6 months!!"), I'm not really impressed. As long as you pay your balance in full every month, your CC interest rate is meaningless.

References

Minimum-payment calculator
About.com on paying off credit cards

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Comments (13)

1.: All I ever think when I get these offers in the mail is: WHY WOULD YOU EVER CARRY A BALANCE ON YOUR CREDIT CARD!? (Thank you for yelling on my behalf.) I don't even know the interest rates on any of the credit cards I've ever held.

The only time it is at all relevant is when you play games with a super-low (0%) interest rate on a very high-limit card. Some people with balls and money to back them up use these offers to invest aggressively over 6-12 month windows. Even if you only do something super-low-risk so you can easily guarantee your ability to pay it off, this is the one time a credit card really does give you "free money."

Posted by jrk at June 23, 2005 11:21 AM

2.: I admire your discipline and agree with your advice.

However....

...my cynicism provokes me to say (perhaps controversially) that the fact you are a student at Stanford gives you more flexibility in managing your finances than other students.

I have recently paid of an outstanding balance of two years and just feel such complete relief. There have been times when I have had to suddenly put large costs on my card - such as car insurance changes, travel costs, suit for graduation interviews etc. Sometimes the money just isn't there when it has to be!

You don't have to have the shopping habits of Karyn Bosnak in order to find yourself short of cash.

Posted by Rachel Lane at June 24, 2005 07:10 AM

3.: You're correct in saying that interest rates do not matter if you pay off the ballance every month but check your statement on how interst is calculated. It is not calculated on the balance remaining after your payment.

My name is Roque Curiel, I used to teach personal financial management at the university level and I am the author of the textbook, "Money Well Spent."

I admire your mission and I think I understand the point of chossing the title you have for your blog. I teach people to achieve financial independence, which is a different state of mind than rich, altogether. There are rich people going bankrupt everyday. FI is a a condition of enough to meet your needs; sadly, rich is a distorted vision of a certain level of consumption (usually) that some people carry around in their heads.

Posted by Roque Curiel at June 25, 2005 07:23 PM

4.: Roque, you're right about the interest accruing on each purchase the month after you have a running balance. Thanks for pointing that out.

Posted by Ramit at June 28, 2005 01:17 PM

5.: Some credit cards use the nefarious two-cycle daily balance, which keeps you paying interest on half of what you've paid off for a FULL MONTH after you make your payment. Watch out for this trap!

Posted by Jerry Kindall at June 29, 2005 09:32 AM

6.: Well, I don't agree with you 100% on not carrying a balance, that's a lifestyle choice.

On a side note, this is what I use my 0% CC's for is this:

Get one that gives you a year at 0%. Then 'pay-off' another CC. When I say pay-off, I mean pay it to another card with no balance. Then have that other card cut you a refund check. Then use that refund check to put it into an investment, like INGdirect.com. Then make ~$100 month off of interest alone, for doing VERY LITTLE.

Posted by Vincent Lauria at July 6, 2005 02:28 PM

7.: Hi Roque,

What a small world !, My name is Roque Curiel also. We share many financial credos. I refuse to carry a balance on our two credit cards and actually get 1% cash back on our Golden 1 Visa card.
I bought your book from Lulu.com but it looks like the printing was not complete, I did not get the seven steps to financial freedom, the book ended abruptly. My wife was surprised when she read the book, she thought that most of the ideas related to my way of thinking, except for the deep quotes. Anyway, we are a family of four with a mortgage of $1506.00 per month and a second (swimming pool) of $467.00 per month. our income is about $105,000 pretax and we have a couple of retirement and colllege funds (Retirement is payed by our employers, college fund is $100.00 per month). We have about $300,000 equity in our house and plan to stay here for quite a while. Any suggestions ????.

Posted by Roque Curiel at July 16, 2005 01:15 AM

8.: Ah, but if your credit card offers a fixed rate balance transfer that is lower than the interest rate of your current student, business or car loan, and you don't use that card for anything else, it can be quite economically smart to carry the balance there rather than with the higher rate lender. For example, we took out a small business loan which I transferred to a credit card at 2.9% fixed. I don't use the card at all. Just make the biggest payments we can every month. We did the same thing with our car loan and the balance on my student loan. Because you can't beat a 2.9% fixed APR.

Posted by Marla at July 22, 2005 10:16 PM

9.: Run these numbers, pay 50% of a credit card balance each month for 6 months or less, calculate the actual real rate of interest.

Posted by Marnell Bookins at August 4, 2006 04:51 PM

10.: I carry a 30% balance on my cc. This is a strategy I am using for building credit. It is a low limit card, that I use only for already budgeted monthly expenses. I do not care what the interest rate is, because the credit it is building for me will allow me to make many times that amount. Credit is like a muscle- use it or lose it. Use it wisely, and it can be an invaluable tool to financial freedom.

Posted by prlinkbiz at August 5, 2006 10:49 AM

11.: Wait, why 30%? Have you heard of your debt-to-credit ratio? Lower is better for your credit score.

Posted by Ramit Sethi at August 5, 2006 10:56 AM

12.: prlinkbiz, you're nuts! i started out with a low credit limit on my first card (I also got it to establish credit), and within 6 months of paying the whole thing off every time, the company raised the credit limit from 500 to 2000. I'm sure they would raise it more if I needed it.

Posted by john at August 7, 2006 10:39 AM

13.: Forgive me, but in my opinion this post and the sentiments expressed in it, are dead wrong.

One thing is absolutely right however - your credit card interest rates DON'T matter, but not at all for the reasons expressed.

They don't matter because if you use it like the very powerful tool it is, your credit card can make you lots and lots of money.

If you borrow say $3000 on a credit card at 2.9%, and use that money as the down payment on a rental property that costs $30,000 and pays you $400 per month in rent, you have effectively just given yourself a 2.9% second mortage - something simply not possible ordinarily. This means you will have gotten into a "no money down" deal, that puts additional cash in your pocket every month, net of expenses, management, everything.

Think I'm making those number up? Think again. I have 4 such properties right now with more coming regularly.

Paying off your credit cards every month being good for your credit is ALSO a total myth. Anyone who has actually put this into PRACTICE knows that the best way to increase your overall credit picture as far as credit cards goes, is to use them, and pay them off over 3 months or so.

How do I know this? Well, I'm no guru... but I would say I'm an "expert" based on experience, not based on what I write on the internet. I paid off a Chapter 13 bankruptcy in January of 2006 (this year - just 9 months ago!) As of a month ago, I had a 718 FICO score. How on earth do I have a 718 score fresh out of bankruptcy? Working the system. Using the rules of the system to my advantage. I have one credit card only, and it had a 700 limit. By using it and paying it down over a couple months at a time, I now have a $1500 limit on that card and could probably get other cards if I wanted to, which at this point I don't (by the way, the best number of credit cards to have is 3).

My partner and I are professional, full time real estate investors. We don't do "fix & flip" or speculate in crazy markets like our home in Northern California. We buy RIGHT, and we make money - consistently. We make returns of 1000 to 3000% (yes, THREE THOUSAND PERCENT) on our cash, when we even use our own cash. This is NORMAL. We also bought a house in the San Francisco Bay Area with 20% equity in it when we walked in the door, then we cleaned it up a bit and added another 100k to the value. But there are no shortage of people who tells us that we can't do what we do. If only they new or were willing to listen...

So in closing... please do not believe everything you read ESPECIALLY on the internet. When it comes to your financial future, you need to do your own homework and get as many different points of view on the subject as possible, and you need to be in many different investment vehicles in order to find the one(s) that suit you best. Personally, I like to make infinite% returns, which is quite easy when you learn how to produce positive cash flow without using any of your own money.

Oh also I would say that a very valuable book for us has been the eBook available at www.learnaboutcredit.com - we put into practice what he writes about and saw immediate results to our credit scores, limits, and overall comfort with utilizing credit to its fullest extent.

Happy investing everyone!

Jonathan van Clute
www.CashFlowRealDeals.com

Posted by Jonathan van Clute at August 24, 2006 01:26 PM

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