How Credit Card Debt Works

We hear a lot about debt — specifically credit card debt. During the second quarter of 2024, credit card balances tipped over the trillion dollar mark for American households. In a tight economy, many people lean on credit cards to make ends meet. That can help build your credit or get you credit card rewards. However, when the fees, interest and balances become too much to manage on a monthly basis, consumers find themselves in trouble. That’s why it’s crucial to know how credit card debt works. 

Credit cards are different from debit cards in several ways. When you make a purchase with a debit card, it pulls money directly from your bank account. This means that if you don’t have enough cash in your account, your debit card will be declined. 

Credit cards require an application to the issuing bank in order to be used. Your annual income, current debt balance, and credit score will affect your approval and the amount of money the bank will lend you on credit. 

Whether you are carrying a credit card balance or just want to learn more about how credit cards work, we will cover the credit card basics, interest and fees, credit scores and strategies for successfully managing your credit card debt.

Understanding Credit Card Debt

It’s important to understand the elements and conditions of credit use before you start using a credit card. If you aren’t familiar with these terms or how they affect your credit card, reach out to your bank for more information. 

• Minimum monthly payment: No matter how much money you owe at the end of the month, your credit card has a minimum balance payment requirement every pay period. However, accumulating interest will likely keep you from successfully paying your balance off if you are only making the minimum payments. 

• Interest/APR: APR stands for annual percentage rate, which measures the interest rate plus additional fees that come with your credit card. As of August 2024, the average credit card interest rate is 24.4%. This is a fee that’s applied to your balance at the end of each pay period. 

• Credit limit: This is the maximum amount you can spend on your credit card. Your credit limit is based on several factors, including your income and credit history.
• Annual fees: Some credit cards charge an annual fee to use them. This fee can range from tens to hundreds of dollars (it is more common with cards with high bonuses). Always factor the annual fee into your decision to apply for a credit card.

Credit cards are definitely not “free money” you can use to make purchases as you wish, as tempting as that may be. Credit card debt is a serious responsibility and should be handled as such. Relying heavily on credit cards can put you at serious risk of financial distress or even bankruptcy.

How Interest and Fees Accumulate

Using the average credit card interest rate of 24.4%, we can show you how quickly interest rates can impact your ability to pay back your credit card balance. If you have a balance of $2,000 on your credit card, and you only pay the minimum payment at the end of the month, you’ll get hit with over $400 in interest tacked onto your balance. And that’s only for one month. Carrying a balance over several months or years with the additional interest puts you at a continued disadvantage when it comes to getting out of debt. 

Annual fees aren’t the only fees you’ll see on your credit card statement, either. Some credit card companies will charge you a fee if you are even one day late making your payments. If you push the limit and try to spend more than you are approved for, you’ll probably get hit with an over-limit fee as well. 

So, think carefully about whether or not you’ll be able to pay off your credit card each month before you start adding more to your balance. 

The Impact of Credit Card Debt on Your Credit Score

There is a lot that goes into your credit score. It’s the number that helps banks determine if you’e a good investment for their money. Your credit score is a significant player in everything from buying houses and cars to opening a credit card. 

Credit cards can be a good place to start building your credit score on a small scale before making large purchases. If you show a regular track record of timely and full payments, you can boost your credit score, which can help you in the future. 

But what happens to your credit score if you apply for too many credit cards or carry too much debt?

A data analytics company called FICO calculates most credit scores. While we don’t know the exact formula for how it is calculated, we do know that these five elements are big determinants of your credit score:

1. Payment history
2. Length of credit history
3. The mix of types of credit
4. How much of your total available credit you are using (Credit utilization)
5. New credit and hard hard inquiries (Credit checks)

If you are trying to repair your credit score while getting out of debt, focus on timely payments and avoid opening up any new lines of credit. Time and consistency can help improve your credit score. 

Common Mistakes That Lead to Credit Card Debt

The power of a new shiny credit card can seem alluring. Credit card companies are brilliant marketers who offer competitive sign-up bonuses and discounts at your favorite retailers, which makes saying no difficult. 

If you have a big purchase coming up, reaching for that credit card is extremely tempting. Buy now, worry later, right? These are just a few of the most common credit card mistakes people make when applying for or using credit cards that result in excessive debt. 

Relying on credit cards for every purchase 

When you get into the habit of swiping your credit card for everything you buy, you may not realize its impact on your bank account. You don’t want the bill to come, only to realize you don’t have enough cash in your account to pay off the balance. To avoid this, only pull out your credit card for intentional, thought-out purchases. 

Not paying attention to interest rates 

When you apply for a credit card, there are a massive number of terms and conditions that you probably didn’t read through. In most cases, the interest rate is in bold, large print. If you do miss it, your wallet will be hurting every time you can’t pay the full balance. Always comparison shop lower interest rates to avoid getting hit with fees you don’t need to pay. 

Missing payments

Interest will continue to accrue if you carry a balance, but missing payments entirely will add fees to your balance and damage your credit score. If you are facing a major life event that is affecting your ability to pay your credit card bill, call your bank. They may have programs to assist you during times of crisis. That’s much better than racking up more fees.

Not understanding credit card terms and offers

Some credit cards will offer an introductory APR of 0%. Sounds great, right? That means you can make purchases without fear of incurring interest charges. This is almost always only for a set period of time. Credit card users will often miss or forget when that time elapses and be shocked when their next credit card statement has them racking up high interest on a large balance. Take the time to carefully review the terms and conditions of your credit card and the promotional offers associated with it. Set reminders on your calendar if you need to pay off your balance before a high interest rate kicks in. 

Maxing out credit cards

Just because you have it doesn’t mean you should spend it. It may feel great that a bank approved you for up to $10,000 of credit, but if you can’t pay that back almost immediately, maxing out your credit card is going to cause you serious trouble. On the flip side, if you are able to regularly max out your credit card and pay it back in a timely manner, you can call your bank and ask for a credit increase. Start small, and once you’ve mastered good financial habits, you can expand your credit. 

Strategies for Managing Credit Card Debt

Coming to terms with your spending and credit card debt balance is the first step to getting your finances back on track. One of the worst things you can do is ignore it and hope it gets better. 

These strategies for managing your credit card debt are meant to help you make a dent in what feels like a very overwhelming process, but they are going to push you closer and closer to financial freedom. 

1. Put a realistic budget together. If you keep falling back to credit card spending, that probably means you aren’t being realistic about your monthly budget. Take a good look at what money you have coming in and what you can reasonably spend within your means each month without turning to credit cards. 
2. Consider a balance transfer credit card. If you can move your debt to a credit card with a lower APR (or even a 0% intro rate), you can relieve some of that compounding pressure from interest accrual. It can even help to transfer multiple balances to one credit card.  
3. Try the debt snowball method. This popular method for paying off debt has you start by listing all of your debts from smallest to largest. Make minimum payments on all debt balances, but put any extra money toward your smallest debt amount. Once that debt is paid off, roll that payment amount into your payments for the next smallest debt balance. Repeat this process until all your debts are paid off. 

How to Pay Off Credit Card Debt

Credit card debt really is the epitome of “if you fail to plan, you plan to fail.” It’s important that you come up with a strategy to get out of debt and stick to it. There are a few different approaches you can take, and it may take some trial and error, but the end result is financial freedom. 

It starts by evaluating your credit card debt from all sources. Consider starting a spreadsheet or document that lists all of your balances, interest rates and important information to help you track payments. 

Put your budget to work and avoid adding unnecessary charges to your credit card. One underutilized tip is to also leave space for building your savings account. A lack of savings may make you want to reach for your credit card when cash is tight. 

Choose your repayment plan. Determine if you should do a balance transfer to consolidate your debt or if you can start the snowball method with the accounts you currently have. 

In extreme circumstances, you can negotiate terms with your creditors if you are aggressively working toward repayment. Reach out to them if there are ways you can speed up paying off your balance. 

Celebrate your little wins and track your process. It’s hard work breaking the cycle of credit card debt, so give yourself a little “credit” for working toward more responsible spending. Track your process in a spreadsheet or budgeting app. This will also help you make adjustments if needed. 

Alternatives to Credit Card Debt

Credit cards don’t have to be the only solution when cash is tight. These alternatives can help you in a pinch. They also have caveats, so always read the fine print. 

• Personal Loan: Borrow a large sum of money for a major expense at a lower interest rate than most credit cards. They will set you up with a fixed repayment schedule. 
• Home Equity Line of Credit (HELOC): This allows you to borrow against the equity you’ve accumulated for your home at a lower interest rate. The application process is long and tedious, but it could be an option if you have the time. 
• Short-term Loans: These can help if you have bills you need to pay before your next payday. They can have extremely high interest rates, so only take what you can quickly repay. 
• Buy Now, Pay Later: Services like Afterpay and Klarna are becoming increasingly popular for online shoppers. Payments are usually split up into four or six payments and are interest-free if you pay it off in the first four payments. 

Tips for Using Credit Cards Responsibly

The most responsible way to use credit cards is to only use them for purchases you know you can pay back and to keep your utilization low. That means you don’t max it out each month just because you can. Remember, it’s not free money. Don’t use it for unnecessary purchases just because you don’t have to pay right away. Then, keep track of your payments to make sure you don’t miss any. Set a reminder to check your balance at least once a week so it doesn’t get away from you.

Also, don’t be tempted by the minimum payment. Pay it off in full each month so you don’t accumulate interest. You can automate this with some credit cards so you never miss a payment. 

Credit cards, when used responsibly, are a good thing. They help build your credit and many offer rewards such as points for travel purchases and cash back. However, if you aren’t careful, it can put you on the path to debt.

When to Seek Help for Credit Card Debt

You don’t have to struggle alone with your credit card debt. If credit card debt is disrupting your ability to pay your regular expenses and you can’t pay more than the minimum monthly payment, you may want to look for solutions to help you break the cycle.

You can use credit counseling, debt management plans or review debt settlement options with your creditor. The best way to make progress with your credit card debt is to get support, hold yourself accountable, and be open to advice and counsel from reputable sources.