Sometimes the best stumps for reform come from the mouths of jesters. Consider this bit from Maria Bamford:

I really think that before giving me a credit card they really should have given me a math test. Like a series of story problems:

• Question Number One: If Maria works as a comedian for $100 a week but spends $20 a day on hair scrunchies, how many years will it take for her to pay off a Taco Bell Gordita she bought in 1992?
• Question Number Two: If Maria’s boyfriend is in a folk band but he only smokes pot every other day, what percentage of the rent will he be able to contribute?

I thought 50%, but the answer is zero. That’s good to know. That’s going to be on the test.

But in all seriousness, there are some truths that consumers should be able to wrap their heads around before being granted access to revolving credit. If you’re new to credit, I strongly recommend you be able to work out each of the following math equations:

Minimum Payment Costs

As penny pinching scrooges, we love to pay the minimum. We want to pay the minimum amount for our used cars, our utility bills, our phone and  Internet service. Heck, we’ll even forgo one of our slices of cheese on the McDonald’s double cheeseburger before we pay a single cent over the minimum. Bottom line: we don’t like to pay more than we have to.

But when it comes to your credit card balance, you shouldn’t pay the bare minimum just because you can get away with it. Here’s why:

Let’s say you have $2,000 in credit card debt.Your minimum payment (typically 2%) is $40 a month and your APR is 18%. Guess how long it’ll take you to pay that off? The answer: just over 24 years. Not only that, you’ll pay $4,396.57 in interest. That’s 2 grand and nearly a quarter of a century down the drain.

Now, taking Ms. Bamford’s example, let’s say she abstained from hair scrunchies for one day a month and applied that extra $20 to her credit card balance. The debt is gone in just under 4 years and she pays only$793.44 in interest. That’s no typo.

The formula for this doozy is too complicated to keep in your head, but luckily you don’t have to. Just visit the credit card minimum payment cost calculator and hit CTRL – D.

Effective Interest Rate

Think you know the interest rate on your credit card? Think again. That number that enticed you to sign up in the first place is only the quoted, or stated interest rate.  Often listed as the APR, this only refers to the number that they use when calculating your finance charge. If you want to figure out how much you’ll actually pay over the life of a loan, you need to understand your effective interest rate.

Let’s say that your APR is 18%. Let’s say, again, that you have a balance of $2,000. You can’t figure the interest you’ll be charged on that over a year by simply multiplying the two figures (if you did, you’d get $360). That’s because your lender compounds the interest every month. This means that each month, the bank multiplies your APR by your balance and tacks the number on to your principle. The next month, they do the same thing, but this time they multiply it by the new balance. So, in reality, you’ll pay $391 in interest in a year.

This formula is another one that doesn’t bear memorization. Instead, bookmark the effective interest calculator and use that when budgeting. This comes into play especially when it comes to deferred interest, which is our next topic.

Deferred Interest

Ever been offered to buy something with zero payments for 12 months? If you are, don’t mistake it for a freebie, because it’s anything but.

The thing to remember about department store purchases with zero payments for a year is that if you’re not making payments, then your principle isn’t getting any smaller. Meanwhile, the interest on your principle is being tacked on and squirreled away, waiting to be presented to you on your purchase’s first birthday. That’s what that line in the fine print means when it says: “Interest will be charged to your account from the purchase date if plan balance is not paid in full within the promotional period.”

Let’s do some more math.

You walk into a big box store intending to buy a $1,000 TV. But wait, says the sales guy, why not buy this other TV that’s twice as expensive instead? “I don’t have that much money,” you say, to which he responds: “Hey, no prob. You don’t have to make any payments for the first year.”

So you buy the $2,000 gadget, assuming that you’ll be able to scrape together an extra $1,000 by next year.

But wait. If, by chance, you don’t pay off the balance on your purchase before the promotional period ends, you won’t owe $1,000 more than you intended to pay, you’ll actually owe $1,536.48 more than you intended to pay. That’s presuming a balance of $2,000 at an APR of 24% compounding 12 times in one year.

Our advice: If you can’t afford it now, you probably won’t be able to afford it later – especially with hundreds of dollars of interest tacked on. Pay in cash for what you budgeted for.

Debt to Credit Ratio

One of the big factors that goes into your credit score is your debt to credit ratio. This is any easy one to figure out, but a harder beast to tame. To get your credit to debt ratio, simply do the following:

• Add up all your credit card debt and any other revolving credit debt
• Add up all your credit limits
• Divide the first number by the second number.

Simple, huh? But what does it mean? A lot.

According to Consumer Reports, card users with a debt to credit ratio above 30% are at risk for having their credit limits slashed by card issuers. Those with ratios above 50% are at an even greater danger. And, of course, having your limit taken down effectively increases your ratio, which looks pretty bad on a credit report (a one-two punch).

So, let’s say you have three credit cards, each with a credit line of $5,000. On one card, you have $1,000. On another, you have $1,500 and on the last you have $2,000. Add those up and you’ve got $4,500 in debt vs a $15,00 credit line, putting you right at 30% debt to credit ratio. Two of your card issuers get jumpy and decides to reduce your limit to $3,000, taking your grand total down to $11,000. That means your ratio is now 41%. Ouch.

Now, let’s say you exercise your rights under the CARD Act and close out one of your credit cards and transfer the balance to one of your existing cards, effectively consolidating your two lowest balance accounts. You now have $4,500 in debt vs a $10,000 credit line for a 45% debt to credit ratio. Even worse.

Last scenario, let’s say you pay off your lowest balance account and close it. Now you have $3,500 debt vs a $10,000 credit line for a 35% debt to credit ratio. Ironically, you’re worse off (at least as far as your credit score is concerned) than you were when you were deeper in debt.

So, instead, what you should do is pay off the debt and keep the account open – especially if you’ve had the account for some time (that’s length of credit history, and FICO smiles upon it). Repeating the same scenario as above, you’ve got $3,500 in debt and $15,000 in credit for a 23% ratio. You’re below the threshold. Weird, huh?

Adding up Fees

The last lesson for today – the true cost of fee-based conveniences. I’m talking about cash advance, over-the-limit fees and overdraft fees (though the last one only applies to debit cards). A credit card, used correctly, can actually end up costing you very little.  But if you utilize all the extras, then you can be in for a big bill. It’s kind of like eating at a restaurant – sure, they’ve got sandwiches for $7. But add on a soda ($3), a salad ($5), a dessert ($6) and a tip ($4) and you’re looking at a $25 meal. A la carte items for your credit card nickel and dime you in the same way. Here are a couple common fees to avoid that can really add up:

• Cash advance – For getting cash from an ATM using your credit card, you pay a 2% (or higher) surchage plus a special, higher interest rate with typically no grace period. So, start with the $100 you pulled out, plus the surcharge ($2) times a 23% effective interest rate that accrues until you pay it off 28 days later (when you receive your credit card statement) and you’ve paid about $25 in fees.
• Over-the-limit charges – Soon to be outlawed, but for now, you can get charged an over-the-limit  fee averaging between $19 and $39 for each transaction. So, you go out and buy a coffee, a meal, gas and a snack before getting home and realizing that your over the limit and you’ve got four penalties for $20 each at a grand total of $60 smackers for not realizing you were over-the-limit.
• Overdraft fees – These work the same way, but are harder to catch because of the odd way that banks clear checks. Let’s say you wrote your rent check and handed it to your landlord 0n the same day you deposit your paycheck. Also, on that same day, you buy a coffee, a tank of gas, a meal and a snack. Now, let’s say you were teetering near the red to begin with, and your bank first processes your rent check, which puts you in the negative. Then they process your other four purchases, racking up a total of 5 overdraft fees. Then they post your deposit, which is instantly eaten up by your fees. Of course, they could’ve processed your paycheck first and saved you from all those fees, or they could’ve even processed the smaller purchases first and only charged you one overdraft fee. But that’s not usually how they operate.

Those are the most common fees that confound card users, but there are hordes more. Watch out for service charges for rewards program enrollment, overdraft protection enrollment, payment protector, security monitoring and other extras.

But the real takeaway math lesson here is to never run close to the edge. If the bank says that it takes 2 to 5 business days to process checks, assume that it’ll be 5 days for your deposits and 2 for your debits. Cynical, maybe. Safer, yes.

That’s all the math my brain can handle for today. Any other essential story problems we should know about? Share with the class in the comments below.

Photo by NizhoniGrl

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2. Common Credit Card Myths and Misconceptions
3. Top Ten Reasons to Pay off Your Credit Card Debt
4. Five “Convenient” Services Offered by Your Credit Card Company That You Should Think Twice Before Accepting
5. 10 Questions and Answers at Master Your Card