Credit Cards have been and always will be a heavily discussed topic among all of us. It is one of the most controversial forms of money or credit lines available to us, and yet has earned itself a very poor reputation. And despite this poor reputation, credit cards have not been out of the finance scene at all. So why are these back-and-forth judgments towards credit cards? Let’s find out.

What Are Credit Cards?

‘Credit Card’ itself is a plastic card with an electronic chip, offered by a financial institution, usually a bank, to a customer. This card facilitates a pre-defined credit or loan amount to the holder of the card on a very short-term basis. The holder of the card can use the card to make purchases up to the credit limit and a certain portion of the payment has to be made within a defined period, usually a month. The most common types of credit cards are VISA, MasterCard and AMEX. However, any financial institution can offer their own credit cards subject to the approval of the Central Bank of the institution’s country.

Why Are Credit Cards Considered Evil?

Credit Cards give the holder a temporary line of credit which can be quite helpful to manage their cash flows. However, the general opinion is that credit cards are evil and most finance gurus advice to refrain from using credit cards altogether. Why?

Most often than not, people will use a credit card and not settle the used credit amount within the stipulated time period. Then things get tricky. A credit card agreement comes with a clause of penalties for delayed payments, which is the sole purpose of the financial institution issuing a credit card. This interest becomes the revenue stream for the card issuing company. Once a cardholder does not, or delay a settlement of the card balance, on average, an interest of above 20% would be charged on the utilized amount of the credit card.

How Does Credit Card Interest Work?

Credit Card interest calculates on something called the ‘Average Daily Balance (ADB). How this works is, the financial institution calculates the number of days your card holds different totals. For an example, lets say you had a balance of $1,000 at the beginning of the month and you did not spend a dime for the rest of the month. Then your ADB would be $1,000 ($1,000*30days/30days). Let’s say you spend $500 on 15th of the month, getting you to a closing balance of $1,500 at the end of the month. Then your ADB would be $1,250 (($1,000*15days+$1,500*15days)/30days).

Now to the interest rate. Let’s assume an interest rate of 20% for this example. We need to arrive at a daily interest rate for this calculation. So 20% / 365 days = 0.00054%. Now this rate is to be adjusted to the number of days of credit outstanding, in our example 30 days. So the interest rate used at the month-end would be 1.62% (0.00054% * 30 days). Now, we use this rate to multiple by the ADB calculated above. The financial institution will charge an interest of $20 ($1,250 * 1.62%). Watch this video which explains the same interest calculation.

If you were in a cash crunch to settle off the original credit card statement balance, an additional interest charged on top could really be a pain point. And this interest charge adds on to the outstanding balance to make the next month’s payment even larger.

This is the trap of credit cards and why most people dislike them despite using it them on a daily basis.

How to Avoid the Credit Card Interest Trap?

The solution is really simple. Never use a credit card beyond your ability to settle it. Yes, this defies the purpose of having additional credit. But it certainly is better than crawling down a debt trap and suffering in the eternity.

So, use you credit cards wisely and you will be very well off.