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Pay Your Credit Cards The Right Way

How much do you pay each month on your credit cards? And, do you pay as soon as the bill comes, or wait until the due date approaches?

Most people have heard the following story, or something very similar: If you charge $3,000 on a credit card at 17% interest, and only make the minimum payments, you won't have the balance paid off for 35 years. And, you'll end up paying more than $11,000, or almost four times the original debt amount. Who wants to do that? If you have credit card debt, you might be surprised at how changing your payment habits a little can make a big difference.

How Credit Card Interest Really Works
To really understand credit card interest, you need to understand the concept of average daily balance.

Most credit card companies use what's called the average daily balance method in order to calculate how much interest you owe. Under this method, your card issuer averages your balance each day in the monthly billing cycle, then multiplies the result by your APR divided by 12 (your monthly interest rate).

So, if you buy something for $500 at the beginning of the billing cycle, but pay it off in full 25 days later, you'll owe no interest whatsoever. However, if you leave even some of the balance, your credit card issuer calculates your average balance during the billing cycle and uses it to compute your interest.

Let's say you pay $400 of that balance after 15 days, leaving just $100 at the end of the month. Instead of charging you interest on just the $100, you'll pay interest on your average daily balance of $300 (15 days at $500 and 15 days at $100). So, keep this in mind when deciding whether or not to pay your full balance.

The effect of paying sooner in the month
If you carry credit card balances, a great habit to get into is paying your bill as soon as you get it. Basically, the sooner in the billing cycle you pay, the lower your average daily balance will be, and the lower your interest will be.

So, if you have a $1,000 credit card balance, making a $100 payment on the first day of the billing cycle will make your average daily balance $900 (or just above, depending on when your payment posts). But if you want until the last minute, you're average daily balance will be right around $100.

This can end up saving you lots of money, especially if you have high credit card debt, or if you pay down a significant portion of your debt each month.

Doubling the minimum payment can save you thousands
Consider this situation: you have $4,000 in credit card debt at 18% interest. By paying $80 per month (well above most "minimum" payments), you'll pay off your debt in 93 months, or just under eight years.

By doubling the payment to $160, you'll cut that repayment period into just one-third of that time, and save yourself more than $2,300 in interest. And, the effect if even more dramatic if you can swing an even higher payment. It's definitely worth it to focus your extra cash toward paying down high-interest debts. Even raising your payment by 50% each month nearly cuts your repayment time in half.

Consider the difference in repayment time for various monthly payments toward debt. Even paying $10 extra per month can save you lots of time and money.

Remember the ultimate goal
While saving money on interest is definitely nice, it's not the only goal here. The point here is that by paying early in your billing cycle and increasing your payments, more of your money goes toward paying down your debt than into the pockets of your credit card company.

This will help you wipe out your credit card debt faster and more efficiently, but once you do that, you should try to keep it that way. Paying no credit card interest at all is a winning situation, both for your finances and for your credit score.

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Matthew Frankel

Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!

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