Feb. 3, 2009 at 8:00 AM ET
Maybe two years ago you could let that $10 late fee slide or forget to question that $29 overdraft fee. But the world has changed. Now, everyone is taking a much closer look at their finances and their monthly bills. We're here to help.
Today, we begin an in-depth series exposing hidden "gotchas" in your financial life. The "How to Save Money On…" series will offer detailed steps and suggestions to avoid booby traps and preserve your hard-earned cash. We begin with one of America's main financial menaces: Credit cards.
Americans hold just shy of $1 trillion in revolving debt on their credit cards now, a steep jump from 2005, when revolving debt was $824 billion. The Federal Reserve shows the level of credit card debt has remained mainly flat since the middle of 2008 though, indicating that as the screws started to tighten on the economy in 2006 and 2007 many Americans turned to credit cards to get through the tough times. That spigot is now being slowly turned off, as banks tighten lending standards and lower credit limits. At the same time, interest rates for many cardholders are skyrocketing, so the squeeze is coming from all directions.
That's why it's more important than ever to use good habits around this bad debt.
I know half of you pay your credit card bills in full each month and think you have nothing to learn from a story about saving money on credit cards. I wish that were true. But card-issuing banks are continually using new tricks to force consumers into occasional slip-ups. Some of these tricks will be barred by new bank regulations, but not until July 1, 2010, so you need to know about them now.
Those who don't pay your balances in full each month are paying interest charges. Some are "serial revolvers," who always carry a balance on their cards; others are "occasional revolvers," who borrow through credit cards once in a while. I call this group "holiday credit card users," because they only run up big balances once a year, perhaps around holiday gift-giving time.
Either way, both groups can benefit from the three tips below. And even those with their credit card house in order should read on because you're not immune from late fees. The third tip will help you avoid those.
1. Keep a "clean card"
There's a point when a credit card user flips from a borrower to a revolver: When you start focusing more on your monthly payments than your total debt. No matter how large your debt, if you keep a grasp of the total and keep on top of your plan for paying that off, you are building toward something. If you focus on your monthly payment, you are in survival mode. The "I don't care, I owe so much anyway" mode isn't far behind. You must avoid this slippery slope.
The clean card strategy is one way. It’s based on this simple premise: You should never pay interest charges on everyday purchases. Instead, always have at least two credit cards in your wallet -- think of one as your everyday "clean card," and one as a line of credit.
Why? Let's say you generally pay your bill every month, but this year you spent $3,000 on travel and gifts for Christmas. Then, when your bill came due Jan. 22, you paid the usual $1,000 and figured you'd pay the rest over the next few months.
At this point, most consumers just keep right on spending with that debt-laden credit card, buying lunch and train tickets as usual, racking up their usual $1,000 in monthly expenses. That's exactly what credit card issuers want you to do, but it's a big mistake.
Consumers who pay their bill in full and on time every month enjoy what's called a "grace period." They never pay interest, and have about 30 days grace before charges kick in. But consumers who fail to pay on time fall from grace. From that point onward, they pay interest on every single purchase they make. That stinks, and it's a very bad way to use credit cards. Buy lunch for $5? You're paying interest on that money before you eat the first French fry.
Back to the example above to see what that means in real dollars. Let's say you typically spent $1,000 a month and paid in full -- until the holiday spending spree. To keep the math simple, let's use a 30 percent interest rate. That $1,000 in everyday spending, borrowed for an extra 30 days during the month, will cost you $25 each month. If you take four months to pay off those holiday charges, it'll cost you $100. Take all year to catch up and it costs $300. The larger the debt, the larger the grace period "penalty." If you carry a $3,000 balance -- perhaps from a misguided quest to accumulate miles or points -- you could be spending $1,000 per year in unnecessary interest charges.
Instead, use the "clean card" strategy. Always have one credit card in your wallet that you pay in full each month. That way, you'll always have "grace." In the example above, you'd stop using that primary credit card the day you couldn't pay the bill in full any more. You'd switch to the clean card and enjoy interest-free French fries.
Obviously, at some point during the catch-up period, another unexpected cost may arise, such as an expensive auto repair. Keep that off your "clean card," so it stays clean. Instead, use the second "line of credit" card. If you've planned ahead, this card also has the lowest interest rate of any in your wallet. You might even call and negotiate a lower rate, as one Red Tape reader recently did ("Want a better rate? Just ask") – though as we've mentioned, those are getting hard to come by.
The main idea of the clean card strategy is to pay for regular expenses like restaurants and gas as you go. But the benefits go beyond saving money on interest. You will gain a firm grasp of your total debt. Even if the news is dismal, it's always better to know what you owe, and that number will stare up at you until you pay it off. If that figure is split between 15, 20, or 30 small purchases on several cards, it severely confuses matters. I think it's the chief reason most credit card users lose track of what they owe, and how long it will take to repay their debts.
For an accurate accounting, use a repayment calculator, like this one, to determine how long it will take to repay your credit card debt.
Consumers may see similarities between the clean card plan and other advice you'll see about using a debit card for purchases to avoid running up credit card bills. That can be effective for consumers who just can't control their credit card spending, but using debit cards for everyday purchases is asking for trouble. It's far too easy to lose track of your checking account balance and run the risk of pricey overdraft fees. (I've covered the debit vs. credit debate before).
2. When you pay (and buy) matters
Most consumers who owe money on their credit cards wait for their monthly statements to make payments. But that's unnecessary. Credit card companies add interest to your balance every day and compound it. So on Day 2 of the month you are paying interest on your Day 1 balance, plus the interest charged on Day 1.
Paying early is a great way to save money. Here's one example: A full month's interest on $3,000 at 29 percent is $74. Make the payment two weeks early and you'll only owe $33.37.
A more realistic suggestion is to send in partial payments during the month -- perhaps half the money on the 15th, and then the rest on the 30th. Using the example above, you'd owe $53.
For a more detailed look at how much early payment can save you, look at the No Credit Needed blog, which contains a handy downloadable spreadsheet that mimics credit card average daily balance calculations and contains settings for interest rate, beginning balance, etc. Try out various repayment scenarios yourself.
One thing you'll find is that when you make purchases also matters. Purchases made late in the billing cycle cost less than those made early in the billing cycle.
Here's an example: two consumers with a $2,000 balance and a 29 percent interest rate make a $3,000 purchase during the month. One buys on the 5th, the other on the 27th. The first consumer pays $113.62 in interest; the second about half that: $61.18.
This is probably obvious on some level: You pay less interest if you borrow money for a shorter time. But because we've been trained to think in terms of monthly credit card cycles even though banks charge us every day, they have an advantage. Understanding how banks calculate credit card interest can help you save a lot. So, if you can, buy that new refrigerator near the end of the month and pay your bill early in the month.
Even credit card users who pay their bill in full every month or rarely charge more than a few hundred dollars can benefit from automatic payments through online banking. Let's face it, none of us are perfect. We all get busy, go on vacation or occasionally lose a piece of mail. The day will come when you forget to mail the credit card check on time. And when it does, you'll be slapped with interest charges and a late fee.
While you are probably very concerned about the interest charges, it's really the late fee you should worry about.
A frugal card user with a $400 balance and a 15 percent rate would only owe $2.79 after a month. But the late fee could be $30, $35 or even $39.
There was a time when credit card issuers would offer one-time waivers of late fees to good customers. Some still do, but facing sinking revenue, many have eliminated such largesse. That means avoiding late fees should be a top priority.
Doing so is easy. You know every month you'll have to send a check to your credit card company. In fact, you probably have a rough idea of how much that is -- say, you always spend at least $300 each month. Set up your online banking account to automatically send $300 to your bank every month, at least five days before the due date. Why five days? Because many banks occasionally shrink their repayment timeframes by a day here or there, triggering late payments. You want to stay ahead of that.
Each month, you can go in and manually adjust the amount so it reflects your bill. But that one month you forget -- you'll be covered. You'll have to pay interest on the unpaid balance, but that will be small potatoes compared to the late fee you've avoided. And, if you send the full payment as soon as you realize your error (as opposed to waiting until the next bill arrives) you'll save even more money.
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