Explaining Credit Card Debt
Revolving debt includes debt from credit cards. As long as you make enough payments to keep your balance below your credit limit each month, you are allowed to borrow money month after month. Unlike installment loans, which are closed once the balance is paid off, they can use credit card accounts indefinitely. However, this debt can quickly outpace you, ruining your finances and credit score. Continue reading to learn more about how to use your credit card responsibly and avoid falling into debt.Examples and Definitions of Credit Card Debt
As long as you make the minimum monthly payment, credit cards offer a line of credit that you can use without restriction until you reach the limit. For this reason, credit card debt is also known as revolving debt. No matter how high your credit limit may be, it's generally recommended that you never charge more than you can afford to pay back at the end of each month. When you don't pay off your balance in full, interest is charged on the debt, which will continue to accrue until you do, putting you further behind. Consider using a $500 charge on a Visa card with a 15% APR as an illustration. Depending on the conditions of your credit card, paying only the minimum amount due each month on that $500 balance could end up costing you an additional $100 to $200 over time.The Process of Credit Card Debt
Unsecured debt is credit card debt. It isn't secured by a piece of property, like your car or house, that the lender could seize and sell if a borrower stopped making payments. However, not paying off your credit card debt can have a negative impact on your credit history and score. Credit card debt will build up if you don't pay off your entire balance by the due date each month. Interest is assessed monthly card balances in the form of an annual percentage rate (APR).Note:
The type of card, the bank issuing it, and the cardholder's credit history affect the APR significantly. Interest rates on credit cards are typically variable. They are based on the prime rate, which is the current market rate and is connected to the Federal Reserve's benchmark fed funds rate. When the Fed changes this target rate, a cascading effect affects your rate and the cost of your credit card debt.Average Interest Rate on American Credit Cards
Your monthly minimum payment is what credit card companies require you to make. It's typically only a small portion of your balance, between 1 and 2 percent, plus any applicable interest and fees. There is interest on interest. Every time you make a payment that is less than the total balance, you will be charged interest; the less you pay, the more interest you will owe because credit card interest accumulates. Your likelihood of owing significantly more than what you initially charged on your card increases the longer it takes you to pay off the debt.How Credit Card Interest Builds Up
If you only made the minimum payment of $25 a month toward a $1,000 credit card balance with a 15% APR, you would accrue nearly $400 in interest, and due to the effects of compound interest, it would take you 56 months to pay off the balance in full.The adverse effects of credit card debt
Contrary to what many think, having credit card debt does not help your credit. This entails charging only what you can afford to pay off each month, paying your bills on time, and attempting to keep all of your balances at zero. Your score rises when you use credit responsibly.Note:
If you pay interest on credit card debt each month instead of investing that money elsewhere, think about what you're giving up. That money could be used as a down payment on a home, as valuable retirement savings, or as an emergency fund. You can determine when you have too much credit card debt using any one of three formulas. Your credit utilization ratio is calculated by dividing your total credit card debt by your credit limit—the amount of credit you use as a percentage of your available credit limits. Right after your payment history, it has the second-largest impact on your credit score. Make sure your credit utilization is the lowest it possibly can be. Your credit score will typically suffer if the ratio exceeds 30%. Your debt-to-income ratio is calculated by dividing your monthly housing and debt payments by your gross monthly income. The amount of your monthly housing and debt payments, including credit card payments that you make out of your pretax income, is indicated by your debt-to-income ratio. When evaluating new credit applications, lenders look at this ratio to determine how much more debt you can—or cannot—afford to take on.Note:
A debt-to-income ratio of more than 40% indicates excessive debt and decreases the likelihood of approval. Keep it closer to 30%, according to many banks and credit counselors. Your credit card debt ratio is calculated by dividing your total monthly spending by your total monthly income. When your payments exceed your budget, this ratio will let you know. If your minimum required payments exceed 10% of your take-home pay after taxes are withheld, it may become difficult for you to pay for regular expenses and necessities.Additionally, there are some non-mathematical indicators that you might have too much credit card debt:
- Every month, your total spending exceeds your total income.
- You're skipping or making late payments on your credit card balances to pay other bills.
- Used one credit card to pay with another.
- You depend on credit cards to pay for regular expenses like groceries and gas.
- Instead of making monthly deposits into a savings account, you're making credit card payments.
- You've given bankruptcy some thought.
Tip:
You can use credit reports to determine your creditworthiness, just like lenders do. Every year, via AnnualCreditReport.com, you are entitled to a free copy of your credit report from each central credit bureau.Important Events
When the first introduced credit cards were in the 1950s, their popularity led to a steady rise in the nation's debt. After the Bankruptcy Protection Act of 2005 made it more challenging for people to file for bankruptcy, consumers turned to credit cards to pay for expenses, and card debt increased. After the Great Recession, the use of credit cards decreased, and balances decreased. In December 2007, the amount of consumer revolving debt in the United States, primarily made up of credit card debt, surpassed $1 trillion for the first time. By April 2011, the national revolving debt balance had decreased to $835.9 billion due to laws like the CARD Act of 2009. American consumers quickly regained their confidence in borrowing. As of 2021, the total revolving debt is once significantly higher than $1 trillion. As of January 2022, the total balances on credit cards alone had increased to $1.043 trillion, far exceeding the 2008 peak. However, despite having large balances, overall credit card use appears to be declining since the pandemic started in 2020.Balance of American Consumer Revolving Debt, 1990–Present
Due to the Fed's two interest rate reductions in March 2020 in response to the COVID-19 pandemic, credit card debt is also less expensive to carry. As of Q4 2021, the average APR was 16.45 percent, just under one percentage point less than it was in 2018. In the majority of active credit card accounts, there are ongoing balances.Credit Card Debt: What It Means for You
Despite their drawbacks, credit cards can be a valuable financial tool and, with careful use and if you take precautions, can raise your credit score.- Learn everything you can. Find out about your current credit cards and any for which you want to apply. Compare the credit card terms and conditions and benefit guides on the card issuer's website. You can use credit responsibly if you know how and when to pay.
- Create card-specific spending guidelines. And follow them. Use your credit card only for necessary expenses, such as groceries or routine auto maintenance, which your budget should already cover.
- Decide on spending caps. Establish your monthly credit limit in advance to avoid credit card debt. Make sure that number is based on what your bank statement indicates you can afford.
- Maintain a modest lifestyle. Credit cards are not a justification for going on a spending spree. They are not "additional" funds. Use cards only to make purchases that you could also make with cash or a debit card.
- Pay promptly. You'll be charged late fees and interest if you don't make your payments on time. Depending on how late you pay, your card issuer may also increase your APR to the penalty rate stated in the terms and conditions of your card if you have trouble remembering due dates, setting up calendar alerts, or automatic payments.
- Monitor your spending. Every week, check your credit card accounts. You might be motivated to pay off the balance more quickly after realizing how easily charges can accumulate and exhaust a credit limit.
- Steer clear of cash advances. Cash advances made with a credit card come with higher interest rates and transaction costs, and there is typically no grace period for such transactions. When you withdraw the advance, not when the billing cycle ends, is when interest is charged.
- Don't randomly open new cards. A wallet stuffed with cards can lead to excessive spending and make it difficult to keep track of your finances. Use credit cards compatible with your regular spending patterns as a priority.
- Periodically check your credit report. It will display your debts, your history of repayment, the number of account inquiries, and the different credit products you're in charge of.
- Take the initiative. If you feel overwhelmed, contact a nonprofit credit counseling service for guidance. If you have any inquiries or worries, contact your card issuers. Don't wait until an account becomes past due.
Main Points:
- Revolving debt on credit cards allows you to repeatedly borrow money up to the limit of your available credit.
- Your available credit is the sum of the credit limit on your card, the amount you've already charged, interest, and any fees.
- Collateral is not used to secure credit card debt. If you don't pay the card balance, the lender can't seize the goods you've bought but could severely harm your credit report.
- Although you are not required to pay off the entire balance on your card each month, doing so will result in you paying interest on top of interest.
