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Shopping Is the First Step
Credit cards are a convenience. It lets you charge a meal on your credit card, pay
for a purchase, or get a money advance.
With credit, you can enjoy your purchase while you’re
paying for it, or you can make a purchase when you’re lacking ready cash.
However, there are strings attached to credit; it usually costs something.
And, of course, what is borrowed must be paid back. If you are thinking of
opening a credit card account, your first step should be to figure out
how much it will cost you and whether you can really afford it.
Then you should shop for the best terms.
What Laws Apply?
The Truth in Lending Act can help you compare costs. It requires banks to
give you certain basic information about the cost of buying on credit.
These disclosures can help you shop for the best deal.
The Finance Charge and Annual Percentage Rate
Credit costs vary. By remembering two terms — the finance charge and the annual
percentage rate (APR) — you can compare credit prices from different sources.
Under Truth in Lending, the bank must tell you, in writing and before you
sign any agreement, what these terms will be.
The finance charge is the total dollar amount you pay to use credit. It
includes interest costs and other costs, such as service charges and some
credit-related insurance premiums.
- Example:
Suppose you borrow $100 for one year, and the interest is $10. If there is a
service charge of $1, the finance charge will be $11.
The annual percentage rate (APR) is the percentage cost (or relative cost) of
credit on a annual basis, which is your key to comparing costs, regardless of
the amount of credit or how long you have to repay it.
- Example:
Again, suppose you
borrow $100 for one year and pay a finance charge of $10.
If you can keep the entire $100 for the whole year and then repay $110 at year’s
end, you are paying an APR of 10 percent. But if you repay the $100 and finance
charge (a total of $110) in twelve equal monthly installments, you don’t really
get to use $100 for the whole year. In fact, you get to use less and less of
that $100 each month. In this case, the $10 finance charge amounts to an APR of
18 percent.
All creditors — banks, stores, credit card companies, — must state the cost of
their credit cards in terms of the finance charge and the APR. Federal law does
not set interest rates or other credit charges, but it
does require their disclosure which will allow you to compare credit costs.
The law states that these 2 pieces of information (finance charge and APR)
must be shown to you before you use a credit card.
A Comparison
Even when you understand the terms a bank is offering, it’s easy to
underestimate the difference in dollars that different terms can make. Suppose
you've purchased several big ticked items on your card and you're 6,000 in debt.
Compare the three credit arrangements in the chart on the next page. How do
these choices compare? The answer depends partly on what you need. The lowest
cost, in terms of total finance charges and total of payments, is available
from Bank A.
|
APR
|
Length
of Loan
|
Monthly
Payment
|
Total
Finance
Charge
|
Total
of
Payments
|
| Bank A |
14% |
3 years |
$205.07 |
$1,382.52 |
$7,382,52 |
| Bank B |
14% |
4 years |
$163.96 |
$1,870.08 |
$7,870.08 |
| Bank C |
15% |
4 years |
$166.98 |
$2,015.04 |
$8,015.04
|
If you were looking for lower monthly payments, you could get them by
repaying your debt over a longer period. However, you would have to pay more in
total costs. A loan from Bank B, also at a 14 percent APR, but for four
years, will add about $488 to your finance charge.
If that four-year loan were available only from Bank C, the APR of 15
percent would add another $145 or so to your finance charges, compared with
Bank B.
Be sure to look at these credit terms before you choose.
Cost of Open-end Credit
Open-end credit includes bank and department store credit cards, gasoline
company cards, home equity lines of credit, and check-overdraft accounts that
let you write checks for more than your actual balance with the bank. Open-end
credit can be used again and again, generally until you reach a certain
prearranged borrowing limit. Truth in Lending requires that open-end banks
tell you the terms of the credit plan so that you can shop and compare costs.
When you’re shopping for an open-end line of credit, the APR is only the periodic rate
that you will be charged, figured annually. (For instance, a bank
that charges 12 percent interest each month would quote you an APR of 18
percent.) Annual membership fees, transaction charges, and points, for example,
are listed separately; they are not included in the APR. Keep these fees in mind
and compare all the costs involved in the offers, not just the APR.
Banks must tell you when finance charges start on your account, so you
know how much time you have to pay your bill before a finance charge is added.
Banks may give you a 25-day grace period, for example, to pay your purchase
balance in full before you pay a finance charge.
Banks must tell you the method they use to determine the balance on
which you pay a finance charge; the interest rate they charge is applied to this
balance to compute the finance charge. Banks use a number of different
methods to arrive at the balance. Study them carefully; they can significantly
affect your finance charge.
Some banks, for instance, take the amount you owed at the start of the
billing cycle and subtract any payments made during that cycle. New purchases
are not counted. This is usually called the adjusted balance method.
With the previous balance method, banks simply use the amount owed
at the start of the billing cycle to compute the finance charge.
The most commonly used method is the average daily balance
method, in which banks add your balances for each day in the billing cycle and
then divide that total by the number of days in the cycle. Payments made during
the cycle are subtracted to get the daily amounts, and depending on the offer,
new purchases may or may not be included. Under another method, the two-cycle
average daily balance method, banks use the average daily balances for
two billing cycles to compute your finance charge. Again, payments will be
subtracted to get the balances, but new purchases may or may not be included.
Be aware that the amount of the finance charge will vary considerably
depending on the method used, even for the same pattern of purchases and
payments.
If you receive a credit card offer or an application, the bank must give
you information about the APR and other important terms of the plan (for
example, annual fees and late payment fees) at that time.
Truth in Lending does not set the rates or tell the bank how to calculate
finance charges, it requires only that the bank tell you the method that it
uses. And remember to ask for an explanation of any terms you don’t understand.
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