How Credit Works

May 25, 2020

If you want to start your investment journey it is very important that you understand how credit works. Your credit score will determine how much you can borrow and the length of your repayment. The higher the credit score, the better the rate on your loan, and the lower the monthly payment. The first step towards building your credit is to eliminate your credit card debt.

If you want to eliminate your credit card debt you have to understand what credit is.

In case you haven’t figured it out yet, the credit system works against you unless you are prepared. And since it is an unfair game, you need to know the rules. Once you know how credit works, how compound interest works, you can start using it to your advantage, instead of being a victim of it.

Here are some facts you need to know.

In 2005, a record 6 billion “pre-approved” credit card offers were mailed to consumers. By comparison, only 10 years before, in 1995, 2.7 billion offers were mailed out.

These offers usually carry a “low introductory” rate which is “fixed” for a set number of months. But, once you read the fine print, you find out that in reality that “fixed” rate can change at any time, and for any reason. What follows was taken from an offer I recently received from a Bank.

“Rates, Fees and terms may change: We reserve the right to change the terms of your account (including the APRs) at any time, for any reason, in addition to APR increases that may occur for failure to comply with the terms of your account” (underlying is mine)

So you may be thinking you are getting a great deal when in reality they can change the rules whenever they want.

Unfortunately, you cannot beat the system. They write the rules to their advantage and we must comply. Every year, credit card companies, banks and financial institutions spend millions and millions of dollars lobbying Congress to make sure laws are passed that benefit them, not consumers.

You simply cannot compete.

The good news is that you don’t need to beat the system; you just need to understand it.

Pre-approved offers are mailed to anyone on a list that a credit card company purchases (usually from the Credit Bureaus), and does not mean that you will definitely get a credit card. They are inviting you to apply, but they are targeting their mailings towards consumers who are more likely to respond and qualify for a card.

If you do not want to receive any more offers, you can call (888)567-8688 to request that Credit Bureaus not include your file in any pre-approved / promotional lists. I encourage you to opt-out, if (for no other reason) to minimize the chances of identity theft.

If you prefer to contact the Bureaus directly, write to the following addresses and tell them you want to opt-out of pre-approval screening:

Equifax Options:

P O Box 7401243 - Atlanta, GA 30374-0123 (800)556-4711

Experian Consumer Opt-Out 

701 Experian Parkway - Allen, TX 75013 (800)353-0809


Attn: Marketing Opt Out – PO Box 97328 – Jackson, MS 39288-7328

(800) 680-7293

There are several more practices that have become more common in the last few years.

One of them is the “Grace Period”, which is the number of days you have to repay your purchase before you are charged interest. Many cards have reduced the grace period from 30 days down to 21 days. With a 21-day grace period, you have less time to pay for your purchases in full and a better chance of paying interest than before. And, if the amount is not paid in full, interest is charged from the date of purchase, not the day you started financing it.

Another practice is the addition of the over-the-limit fee. Many consumers would expect their credit card to be declined if a transaction would put the card over their credit limit. But, increasingly, credit card companies are allowing these transactions to go through, then slapping consumers with an over-the-limit fee of $20, $25, or more.

Late fees are escalating too, adding $30 to $50 to your credit card bill. Not to mention that your interest rate skyrockets. I personally know someone in New York who sent his payment in late, and his interest rate went from 9% to 29% the following month. This is very common.

There is also the Foreign Transaction fee that you get hit with when withdrawing your money from an ATM outside of the States. Keep that in mind next time you travel.

Simply withdrawing money from an ATM that doesn’t belong to the bank means you are going to be hit with two fees. One fee that is charged by the bank that owns the ATM, and another fee that is charged by your bank (not all banks will charge this fee, but most will). Withdrawing $20 from another bank’s ATM could result in $4 to $6 in fees. How many times a year do you withdraw money from other bank’s ATMs?

There are way too many fees to list here, but you get the idea.

Are you asking yourself what you can do to protect yourself?

There are a number of things you can do.

First, you need to check your credit card statements every month. Believe it or not, most people do not check their statements. Check not only your credit card statements but also your checking account and your savings account statements. Look for any errors.

Look for fees, and see if they are correct. If you see any over-the-limit or late fees, call the company and ask (politely) if they can waive them. They will usually waive them, but if you are late again or over the limit again, they may not do it a second time.

Be very careful when mailing your payments. Send them at least 10 days before the due date to avoid late fees. Or set it up so the balance is deducted from your checking or savings account automatically. Contact your bank to find out how to do it.

You can also (and I encourage you to do this) call your credit card companies and ask for a reduction of your interest rate. This may be a little harder to get, but if they don’t want to do it, don’t despair. Call again in a couple of weeks, and ask again. In Part 2 you can read a script you can use when you call.

What is compound interest?

This is the most important concept to understand if you plan to stay debt free forever.

And for you to understand exactly how it works, I’ll ask you a question: What would you rather have, a million dollars in cash right now, or one penny today, two pennies tomorrow, four pennies the next day, eight pennies the next one and so on for the next 30 days?

Most people would choose the million dollars, and it is a good choice, I mean, who wouldn’t want a million dollars? However, the second option is much better. Look at the following table to see the power of compound interest in action:

Day 1: $.01
Day 2: $.02
Day 3: $.04
Day 4: $.08
Day 5: $.16
Day 6: $.32
Day 7: $.64
Day 8: $1.28
Day 9: $2.56
Day 10: $5.12
Day 11: $10.24
Day 12: $20.48
Day 13: $40.96
Day 14: $81.92
Day 15: $163.84
Day 16: $327.68
Day 17: $655.36
Day 18: $1,310.72
Day 19: $2,621.44
Day 20: $5,242.88
Day 21: $10,485.76
Day 22: $20,971.52
Day 23: $41,943.04
Day 24: $83,386.08
Day 25: $167,772.16
Day 26: $335,544.32
Day 27: $671,088.64
Day 28: $1,342,177.28
Day 29: $2,684,354.56
Day 30: $5,368,709.12

This is the magic of compound interest. A penny doubled every day may not seem like much, but the compounding factor is incredible. In fact, Albert Einstein has been quoted as saying “The most powerful force in the universe is compound interest.”

As you can see in the table above, a penny doubled every day gives you over $5,000,000 in just 30 days. This is how powerful compound interest is. And this is what credit card companies are using against you.

When you make charges on your credit card, you pay interest on any balance you carry (balance would be any unpaid amount on your credit card statement). This interest is calculated not only on the initial principal but also the accumulated interest of prior periods.

Compound interest can really hurt you, especially if you are making the minimum payment on each of your credit cards. When you carry a balance, compound interest is calculated daily, which means everyday interest is added to your balance. If you pay the minimum payment on a credit card, you are only making the bank richer.

To show you compound interest in action, consider that if you have a credit card with $5,000 balance at 18% a year, and you were to pay only the minimum payment (let’s say it’s 3% of your balance), it would take you 199 months to pay it off! (Assuming that the rate doesn’t change and you never use your card again). So your account will be paid off in exactly 199 months (over 16 years!) and you will have paid $4,698.46 in interest. This is insane. This is what banks don’t want you to know.  Send them only the minimum payment and they will love you forever. (Source: )

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