Credit cards have a bad reputation in the personal finance world, as they’re frequently the cause of so much financial stress. There are also many misconceptions about credit cards, including whether you should pay off your credit cards in full each month or let your balance carry over from month to month.
So, should you pay off your credit card in full each month? In addition to answering this question, we’ll cover the ins and outs of interest, the benefits of paying off your entire credit card bill, the disadvantages of carrying a balance and common credit card myths.
Your guide to credit card interest
With credit card debt comes interest charges. But you can avoid interest charges by paying your balance in full.
Let’s explore how credit card interest works and how paying off your credit card in full can help you avoid it.
How credit card interest works
Credit card companies may list an annual percentage rate (APR), but they calculate interest using a daily rate. They then apply this daily interest rate to your average daily balance to determine your monthly interest charges. The credit card company then charges you the accrued interest after your billing cycle.
Determining your daily interest rate
Finding your daily interest rate requires a little math, but it’s relatively simple. Start by dividing your APR by 100 to convert it to a decimal. For example, 19% APR would convert to 0.19.
The formula for this would be: 19 / 100 = 0.19.
Next, divide the decimal by 365 (the number of days in a year) to get your daily interest rate. In our example, the daily interest rate would be 0.00052.
The formula for this would be: 0.19 / 365 = 0.00052.
Determining your average daily balance
Finding your average daily balance is simple, but it requires a careful examination of your daily spending. Simply add up your credit card balances from each day in your billing cycle, then divide the sum by the number of days in your billing cycle.
For example, if you have a 25-day billing cycle and maintained a $1,000 balance in 24 of those days, but the balance increased to $1,500 on the 25th day, your average daily balance would be $1,020.
The formula would be: (($1,000 x 24) + $1,500) / 25 = $1,020.
Determining your interest charges
With your average daily interest and average daily balance calculated, you can now determine your daily and monthly interest charges.
To find your daily interest charges, multiply your average daily balance by the daily interest rate. In our example, the daily interest charges would be 53 cents.
Here’s the formula: $1,020 x 0.00052 = $0.53.
Now, multiply the daily interest charges by the number of days in the billing cycle to get your monthly interest charges. In our example, this would equal $13.25.
Here’s the formula: $0.53 x 25 = $13.25.
How to avoid interest charges
Your credit card company doesn’t immediately apply the accrued interest charges to your account after your credit card billing cycle ends. Instead, most credit card issuers offer an interest grace period that runs from the final day of your billing cycle through your payment due date.
During the interest grace period, the credit card issuer will not apply interest charges to your account. If you don’t pay off the balance in full by the due date, the credit card company will charge you interest on the unpaid balance.
With some credit cards carrying interest rates in the mid-20% range, the charges can be significant.
Disadvantages of not paying your credit card in full
The benefit of paying off your credit accounts in full each month is clear, but we must also cover the distinct disadvantages of carrying a credit card balance from month to month.
Can damage your FICO credit score
Many factors go into calculating your FICO credit score, which is the most commonly used credit scoring system. One important factor is your credit utilization ratio — your total credit card balances relative to your credit limit.
The rule of thumb is a credit utilization ratio over 30% can harm your credit score.
If your credit utilization rate is over the 30% mark when your credit card company submits your information to the three major credit bureaus — Experian, Transunion and Equifax — this could reduce your credit score.
A credit score drop can also impact other aspects of your personal finances, such as getting the best terms on a personal loan or mortgage.
Interest charges will rack up
A huge negative to using credit cards, in general, is their interest rate. Even the cards with the lowest interest rates hover in the 13% to 15% range. What’s worse, some cards with the highest interest rates can charge over 35% interest.
If you let a balance carry past the interest grace period and into the next month, you’ll get dinged with significant interest charges. For example, if you carried a $1,000 balance over to a new month on a credit card with a 19% interest rate, you’d pay about $16 in interest charges that month.
That may not seem like much, but it adds up over time, especially if you consistently make only the minimum payment.
If you stuck with the minimum monthly payments until you paid off that $1,000 credit card balance, your interest payments would total nearly $1,700. Plus, it would take 169 months to pay it off.
Can’t help in an emergency
A critical personal finance goal is to save an emergency fund that can support you for 3-6 months, but this can take some time to build up. During the ramp-up time, many people rely on credit cards for emergencies.
If you continually carry a high balance on your credit card, you may not have enough credit available if an emergency strikes.
Myths about paying your balance each month
There are a few misconceptions about paying off your credit cards every month. Here are some of the most common myths.
You must carry a balance to build credit
Some people believe the only way to build credit using a credit card is to maintain a balance. If you pay it off each month, it no longer helps.
This is untrue. Every time you pay your credit card bill on time — whether you’re paying it off or making the minimum payment — you get a positive mark on your credit report. Over time, these positive marks can result in credit score increases, which may open you up to more loan options and lower interest rates.
When you carry a credit card balance from month to month, these positive marks come at the expense of interest charges. However, if you pay off your credit card in full every month, you get a positive mark with no interest charges. It’s a win-win.
You can’t earn credit card rewards
A common fear of paying off your entire outstanding balance each month is the credit card company won’t give you any rewards. However, credit card companies issue their reward points based on purchases, not carrying a balance.
Even if you pay off your entire balance and accumulate no interest charges, you’ll still get all your reward points. If you pay off your balance monthly and avoid interest charges, this suddenly makes using your credit card a profitable venture.
Should I pay off my credit card in full?
The short answer is a resounding “yes.” Paying off your credit card in full not only helps you avoid paying interest, but it has many other benefits, including:
- Keeping your credit utilization rate low
- Keeping your debt-to-income levels low
- Helping you build credit
- Earning credit card rewards without interest charges
On the other hand, there are plenty of downsides to letting your balances carry over from month to month. Not only can it send you into a bad-credit cycle, but it can also cost you hundreds of dollars per year in interest charges and limit your ability to use your credit card in an emergency.