Credit Card Analysis
Learning goals include:
- Careful reading of financial rules and regulations,
- Calculating with interest,
- Calculating recursively, and
- Calculating a revolving monthly balance.
Context for Use
Before beginning this assignment, students should be familiar with the notion of compound interest. This example could be used in a course as a final assessment on compound interest.
Description and Teaching Materials
In a letter from 1993 (Seattle Times), a young adult describes the debt he accumulated as a result of not understanding the finances of buying products with credit cards. In particular, he states his confusion about required minimum payments. A more recent New York Times article also refers to the large amount of interest that is charged to someone who only makes the required minimum payments. In order to fully understand these truths, work through the following calculations.
- Obtain a current credit card offer and read through the terms. Identify the following information (you may have to dig into the "fine print"):
- Credit cards allow the holder to purchase an item and take it home to enjoy while paying for the item at a later date. Purchasers may pay for the item in full when they receive their first statement. For companies that offer "grace periods," no additional interest is charged. However, often people use credit cards when they plan to pay for an item over several months or years. If one does not pay off the entire credit card balance, interest will be charged on ALL purchases, and the interest owed is then calculated from the date of purchase (not the date the bill is received). Thus, there is no grace period at all.
Suppose you have your eye on a nice big screen TV that costs $2,000. You decide to use your new card to make the purchase. Assume that you do not plan to pay the debt off in full at the first billing, so you will be subjected to interest charges each month.
- Suppose you keep making the minimum payment for one year.
- Use a spreadsheet, such as Excel, to keep track of the following quantities:
a. APR (Annual Percentage Rate): Note that there are often different categories (payment, transfer) and rates (introductory and regular). These rates can also be fixed or variable. Determine the regular payment APR for your card. If the rate is listed as variable, indicate how this rate is determined. Does your card have a Default APR? If so, what is it and when does it get used?
b. Grace Period: Most credit cards have a grace period on new purchases. State whether your card has a grace period and when it applies.
c. Does your card have an annual fee?
d. How is the minimum payment determined?
e. What happens if you miss one or more payments?
a. Using the regular purchase APR, determine the monthly interest rate for your card.
b. If your card has a grace period, when you receive your first bill (say, in one month) there should be no interest charge. If you make the required minimum payment, how much will you have to pay the first month? What is the remaining balance (amount you owe) on the card?
c. Assuming you only make the required minimum payment, your second bill will have an interest charge. Assuming you are charged one month of interest on the remaining balance, how much will you be charged in interest on your second bill?
d. Your new minimum payment will be computed by using the starting balance plus the interest charged. What is the minimum payment required on your second bill?
e. Assuming that you again just make the minimum payment, what percent of your payment goes towards interest and what percent goes towards reducing your original balance of $2,000?
f. When your third bill comes, what is the new balance and minimum payment?
a. After one year, what is the current balance on the credit card?
b. After one year, how much have you paid the credit card company?
c. Of all the money you paid the credit card company, what percent went towards reducing the original balance of $2,000, and what percent went towards interest payments?
d. If you keep making minimum payments, how long do you think it will take to pay off the purchase of the TV? An estimate based on your work so far will suffice.
- Statement number (first, second, etc.)
- Interest charged that month
- Current balance
- Minimum Payment required
- Total amount of interest paid to date
How long will it take to pay off the original purchase price of $2,000? How much interest would you have to pay for this privilege?
Teaching Notes and Tips
This example can create many questions from students. It is important to be able to perform some sort of triage on the questions. For instance, it may not be worthwhile to make sure every student is computing the balance in exactly the same manner (is interest added before or after the minimum payment is calculated? Does "balance after one year" mean the amount before or after the payment is made?). What is important is that students understand that every monthly cycle (other than perhaps the first one) should contain a) a starting balance, b) an interest charge, c) a minimum payment calculation, and d) a payment. Whether payments are credited at the end of one cycle or the beginning of another cycle is not of great importance.
Rounding is another cause for discrepancy. In the following calculations, interest rates were rounded to the nearest hundredth of a percent and dollar amounts were rounded to the nearest cent.
Since answers can vary tremendously with different interest rates, it would help to have a spreadsheet available to quickly check to see if students appear to be "in the ballpark" on these calculations.
Answers to question 6 can also vary quite a bit depending on which months students decide to "miss". This is an exercise in assumption making. Students should be able to assume which statements will be missed. The instructor needs to check 1) any late/missed payment fees are added appropriately, 2) the default APR is introduced at the right time (if applicable), and 3) the APR is reset to the original after the correct amount of time.
Assessment Plan 1 (Beginners): All students should complete item 1 before coming to class. Working in groups and encouraging peer-to-peer instruction, students should work through the calculations associated with item 2. Some instructor guidance on organization may prove helpful. Items 1 and 2 can then be assigned for individual homework and collected the following class day. On the second day of the activity, the instructor may wish to show the class how a spreadsheet can be used to quickly repeat the series of calculations from item 2. Using a spreadsheet projected in front of the entire class, the instructor can perform the necessary calculations in order to answer questions posed in items 3 - 7.
Assessment Plan 2 (Intermediate/Advanced): The seven study questions can be used as the basis for a longer written project. Students should be required to create spreadsheets to analyze the various payment situations, the effects of missed payments and the effects of different interest rates.
References and Resources
- A variety of credit card disclosure statements may be found at Bank of America.
- An example of an Excel Spreadsheet (Excel 2007 (.xlsx) 60kB Nov6 09) that can be used to duplicate the types of calculations associated with this example.