The Numbers - Debt, Interest, Limits

Infographic about credit card debt in Canada (source: ratehub.com) (2016)

Average consumer debt per Canadian (source: Equifax Canada)

Credit card debt occurs when a person uses a credit card to make purchases or withdraw cash and is unable to repay the full amount by the due date. Interest and fees are added to the outstanding balance, and if the debt is not paid off, it can accumulate over time. In Canada, 71% of Canadians pay their credit card balance in full every month, meaning 29% of Canadians do not and pay interest (source: Payments Canada).

When it comes to using a credit card, it’s essential to be aware of the crucial aspects of credit card debt, interests, APR (Annual Percentage Rate), fees, and limits. Using a credit card can be a powerful financial tool as it has many advantages, but it is important to understand the costs of borrowing money from lenders, including the interest and APR. Additionally, fees such as annual fees or late payment fees can all add up and impact your budget. By understanding and managing these aspects, you can confidently use your credit card while avoiding financial difficulties.

Additionally, when a credit card holder fails to make a payment on time, usually given a 60-day period, the creditor may raise the interest rate on the credit card. The penalty APR, or annual percentage rate, is a higher rate that is imposed on a credit card account as a result of certain actions such as missing a payment, going over your credit card limit, and insufficient funds. This rate can be significantly higher than the card's regular APR and may apply to all purchases made with the card, not just the missed payment. The penalty APR may be in effect for a set period of time, usually six months, but in some cases, it may be permanent.

Impacts of credit card debt

Credit card debt in the US (source: Federal Reserve)

According to a report by the Federal Reserve, credit card debt in the United States has been on the rise in recent years, reaching an all-time high of $1.08 trillion in 2020. This can be attributed to a variety of factors, including low-interest rates, easy access to credit, and an increase in online shopping. Additionally, the COVID-19 pandemic has led to financial hardship for many individuals, causing an increase in credit card debt as people turn to credit cards to make ends meet. However, carrying high levels of credit card debt can have serious consequences for individuals and their credit scores. According to a study by the Consumer Financial Protection Bureau, individuals with high credit card balances are more likely to have a lower credit score and are at a higher risk for default. Additionally, interest rates on credit card debt can be quite high, with the average APR being around 16%. This means that carrying a balance on a credit card can become quite costly over time.

Credit card interest

When you use a credit card, the bank that issued it is essentially lending you money. To compensate for this, they charge you interest on the outstanding balance, which is the amount of money you borrowed but haven't paid back yet. This interest is usually calculated on a daily basis, so the longer it takes you to pay off your balance, the more you'll end up paying interest. The interest rate can vary depending on the type of credit card you have and your credit score. For instance, if you have a good credit score you may be offered a lower interest rate than someone with a fair or poor credit score.

Typically, credit card issuers use the average daily balance method to calculate interest. This method involves taking the sum of the outstanding balances for each day of the billing period and dividing it by the number of days in the billing period. This calculation gives the average daily balance, which is then multiplied by the interest rate to determine the total interest charged for that period. This process is used to ensure that the interest charged is proportional to the amount of time the outstanding balance is carried.

It's worth mentioning that credit card issuers may have different interest rates for different types of transactions. For example, they may charge a higher interest rate for balance transfers or cash advances than for regular purchases. This is something to keep in mind when using your credit card for different types of transactions.

Relieving/forgiving credit card debt

When you are in credit card debt, there are many strategies you can use to pay off your debt faster and pay less interest.

Budgeting: The most important strategy to relieve your debt and stay out of it is to make a budget and prioritize credit card debt repayment. Credit card debt usually occurs when your spending habits cause you to spend more money than you are making. You must change these spending habits by tracking your spending and cutting down on unnecessary expenses. It is recommended to write a monthly budget, so you prevent adding to your debt, and eventually make enough money to pay it off.

Credit card balance transfer: This option is recommended if your credit card has a high interest rate (19.99% or more). Many companies offer balance transfer credit cards, which often have promotional interest rates for a specific period of time. These cards have interest rates as low as 0%, but they typically last for only 6-18 months. You can transfer some or all of your balance onto a balance transfer card, and pay off your debt at a much lower interest rate. However, it is important to pay off your entire balance before the promotional period ends. Failing to pay the entire balance before it ends will result in you being charged interest on the entire amount that was transferred. Balance transfer cards often have higher interest rates of 24-29%, so a balance transfer is only worth it if you can pay off the entire balance before the promotional period ends. To prevent losing more money, balance transfer card debt should be prioritized above all other debt.

Debt Consolidation: If you have large amounts of debt from different creditors, a method to better handle the debt and pay potentially less interest is debt consolidation. In simple terms, debt consolidation is borrowing money to pay off your debt, resulting in you only owing money to one creditor. This can be done through a personal loan, debt consolidation company, line of credit, or a lending company. Depending on your negotiations, you can pay off the debt at a lower interest rate than if you were to pay all the individual creditors.

When a borrower fails to pay their credit card debt, the credit card company may choose to sell the outstanding balance to a collection agency. Collection agencies are businesses that are hired by creditors to collect unpaid debts. Once the debt is in the hands of a collection agency, they will make efforts to recover the money from the borrower. If the borrower is unable to pay the full amount, the collection agency may offer a plan for debt forgiveness or debt settlement.

Some methods of forgiving credit card debt are:

Debt settlement: A borrower and collection agency can come to an agreement where the borrower pays a lump sum that is less than the total amount owed, and the collection agency forgives the remaining debt.

Debt management: A borrower can work with a credit counselling agency to create a plan to repay their debt over time. If the borrower successfully completes the plan, the collection agency may forgive a portion of the debt.

Bankruptcy: A borrower can file for bankruptcy, which may lead to the discharge or forgiveness of some or all credit card debt.

It's worth noting that forgiving credit card debt can have a negative impact on a borrower's credit score and credit history, making it harder for them to get approved for another credit card or loan in the future. Additionally, debt forgiveness may be considered as income and subject to taxes, so it's recommended to speak with a financial advisor or attorney before pursuing debt forgiveness to understand any potential tax implications.

APR

APR stands for Annual Percentage Rate. It is the annualized version of the interest rate on a credit card. It takes into account not only the interest rate but also any other fees or charges that may be associated with the credit card, such as annual fees or balance transfer fees. The APR represents the total cost of borrowing money on a credit card over the course of a year. It is typically expressed as a percentage. It's also important to be aware that the APR can vary for different types of transactions such as purchases, balance transfers, and cash advances and it can also be different for different credit cards. Additionally, APR can be either fixed, meaning it stays the same over time, or variable, meaning it can fluctuate based on a benchmark rate such as the prime rate. By comparing the APR of different credit cards, consumers can get a better understanding of which card will be the most cost-effective for them to use.

It's important to note that credit card issuers may offer promotional APRs, such as 0% APR for a certain period of time, to attract new customers. For example, a credit card issuer may offer a 0% APR for the first 6 months for balance transfers, this means that you will not be charged interest on balance transfers for the first 6 months from the moment you open the card. However, it's important to review the terms and conditions of the offer, as there may be other fees or restrictions that apply.

Here is an example of interest rate vs APR:

You have a credit card with a 24% APR and a $1,500 balance. During the month, you make a $200 purchase and a $100 cash advance. You also have a $35 annual fee. At the end of the month, your total outstanding balance is $1,835 ($1,500 + $200 + $100 + $35).

The Interest rate is typically applied to the outstanding balance on a daily basis, so let's say for this month the interest rate is 2% per month, which is equivalent to 24% per year. Therefore, the interest for this month will be $36.70 (2% of $1,835)

On the other hand, the APR takes into account not only the interest rate, but also any other fees or charges that may be associated with the credit card. In this scenario, the APR would be the total cost of borrowing money on the credit card over the course of a year, including the $35 annual fee and the $36.70 interest for this month, so it would be 24%.

In this scenario, you can see that the interest rate is only a part of the APR, which takes into account additional charges as well. And that's why APR is a more comprehensive measure of the true cost of borrowing.

Note that not all credit card issuers calculate APR in the same way, so it's always good to check the terms and conditions of your credit card.

Credit card limits

% of Canadians with different credit card limits (source: Bank of Canada)

All credit cards have a maximum amount of money you can spend, known as the credit limit. When you first get your credit card, the limit is set. However, you are able to request a reduction or increase in your limit. Before increasing your limit, your credit card issuer needs to get your permission verbally or in writing, which is known as an express consent. To decide your credit limit, issuers looks at your income, debt, credit score, length of credit history, and more. For example, one with a strong credit score will receive a higher credit limit. Additionally, your credit limit can also affect your credit score. If you utilize a large portion of your credit limit, or if you near your limit, it can negatively impact your score, as it shows that you are struggling to pay off your balance. To maintain a good credit score and possibly lower it, it is recommended to use 30% or less of your credit limit.

Credit card fees

Credit card fees are charges that a credit card issuer may impose on cardholders for various services or transactions. Some common types of credit card fees include annual fees, late payment fees, balance transfer fees, and cash advance fees. Understanding the fees associated with a credit card and how they can impact the overall cost of using the card is extremely important, as all these fees can accumulate over time and create long term financial problems.

Annual fees: Many credit cards charge a fee every year for having the card. They are known as annual fees and can range from $50 to $700. Although some cards do not charge annual fees, the ones that do charge them often offer incentives and rewards such as cash back or Air Miles. Typically, the higher the annual fee, the more lucrative the incentives and rewards are. Annual fees remain the same every year for most cards, but some cards may not charge the fee for the first year of holding the card.

Late payment fees: If you pay your credit card bill late, most credit cards will charge a late payment fee. These fees usually range from $15 to $35, and the amount is based on the size of your balance. Some credit cards will charge more if you pay late multiple billing cycles in a row.

Interest charges: Interest charges are charges that a cardholder must pay when they carry a balance on their credit card. These fees are typically charged as a percentage of the outstanding balance, and the rate can vary depending on the card issuer and the cardholder's creditworthiness. Interest rates are based on the cards APR.

Foreign transaction fees: Foreign transaction fees are charges that are applied to credit card purchases made in a foreign currency or on foreign soil. These fees typically range from 2% to 3% of the total purchase amount and are added to the cost of the transaction by the credit card issuer.

Balance transfer fees: Balance transfer fees on credit cards are typically a percentage of the amount being transferred from one credit card to another card, with a minimum fee. For example, a common fee structure is a 3% balance transfer fee with a $5 minimum. This means that if you transfer a balance of $1,000, the fee would be $30 (3% of $1,000), but if you transferred $100, the fee would still be $5.

Cash advance fees: A cash advance fee is a fee that is charged when you take out cash using your credit card. The fee is usually a percentage of the amount of cash you take out, and it can vary depending on the credit card issuer.

Over-the-Limit fees: Over-the-limit fees are charges that may be imposed by a credit card issuer when a cardholder exceeds their credit limit. These fees can vary depending on the issuer and the cardholder's account terms, but they are typically a fixed dollar amount.

Returned payment fees: Returned payment fees on credit cards occur when a payment made to a credit card account is returned or rejected by the bank for insufficient funds or other issues. These fees can vary depending on the card issuer, but are typically around $25 per returned payment. These fees can add up quickly and can damage a person's credit score if multiple returned payments occur.

To get lower fees on your credit cards consider these options:

1. Compare credit card offers from different issuers to find one with lower fees.

2. Look for credit cards with no annual fee.

3. Pay your bill on time to avoid late fees.

4. Use your credit card responsibly and maintain a good credit score to qualify for lower interest rates and fees.

5. Read the card holder agreement before signing up to know about the fees.

6. Try to negotiate with your card issuer for lower fees.

7. Consider using a credit card with rewards and benefits that offset the cost of the fees

Avoiding credit card debt

The following are several ways to avoid becoming indebted on your credit cards:

1. Having a clear understanding of your income and expenses is one of the most effective ways to avoid credit card debt. Making a budget can assist you in identifying areas where you may be overspending and making adjustments accordingly.

2. Whenever possible, pay off your credit card balances in full each month to avoid interest charges. In addition to avoiding unnecessary debt, you will also prevent interest from accruing on your balances. Consider a low-interest credit card: If you plan to carry a balance on your credit card, it's important to shop around for an interest rate that is lower. The long run savings from this will be significant.

3. You should be aware of fees and penalties that can apply to credit cards. Some credit cards charge late fees, overdraft fees, and annual fees, among others. By understanding these fees, you can take steps to avoid them and reduce the cost of using your credit card.

4. Reduce the number of credit cards you have: Having multiple credit cards can increase your debt risk. Having one or two credit cards and using them responsibly is better than having many.

5. To avoid accumulating credit card debt, use cash or debit cards whenever possible instead of credit cards.

By following these steps, individuals can take control of their finances and avoid falling into credit card debt. It's important to always keep in mind the long-term financial implications of credit card use and to use them responsibly. For more advice on using credit cards, visit Credit Card Tips and Advice.

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