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How Credit Card Companies Apply Your Payments

Ever wondered how payments to your credit card are applied? It’s all spelled out in the payment allocation provision of your credit card agreement. Generally, this is within a section labeled something like “Payments” or “Making Payments.”

From my Capital One card agreement:

We may allocate payments and other credits and proceeds among the various segments of your account, and to charges and principal due within each segment, in any way we determine, including balances (including new transactions) with lower annual percentage rates (APRs) before balances with higher APRs.

What Kind of Interest Are You Accruing?

The “segments” referenced above are different ways that you can use your card–whether promotional offers or just the different rates for different types of card use. Three of the possible segments of my card are a) regular credit card transactions b) balance transfers and c) cash advances. The respective rates on each are a) 12.9% APR b) 12.9% APR and c) 22.9% APR.

So suppose that I get a cash advance of $150 and spend $150 with my credit card. I send in $150 right away (because cash advances have no grace period) and want it applied to the cash advance balance. Well, the clause above says that the credit card company has the right to allocate that money as they see fit. And they’ll use it to pay off the credit card part, first, not the cash advance. They’ll earn more interest that way.

A Sample Payment Application

Let’s run some numbers to show how that would play out.

Suppose Micah and I had $5000 of debt at 30% APR on his old credit card. Now, we called the company and they agreed to lower our APR to 13%.

But this APR would only count towards new purchases (they don’t always say this part, so be sure to check with them. it’s hidden in the fine print). Now we go out and spend $1500 on a couch. Dining room set? Flat screen tv? $1500 is almost a month’s expenses so I can’t imagine spending that much on any one thing. But we do it anyway.

We send in $250 to start paying it off. The $250 will be applied to our $1500 purchase, not our $5000 of old debt. So the $5000 will continue to accumulate interest at the old rate.

If we pay $250 every month, we’ll eventually pay off the whole thing. But we will have paid more money total (because of the higher APR) than if we’d gotten them to apply our payments to the balance with the higher APR. In this case, $369 more would go to the CC company.

I worked this out in a spreadsheet assuming 30% APY means 2.5% per month. 13% means 1.08% per month. I didn’t use the daily rate, so it’s not as precise as the actual interest would be.

Balance Transfers

This is particularly important to remember if you’re doing a balance transfer. Many cards offer excellent 0% APR rates for balance transfers and they’re a great way to pay off a loan for less. Why do the companies let you do this? They hope you’ll slip up and not pay it all off, they hope you’ll use the card once the transfer is paid off, but they really really hope you’ll use the card before paying off the balance transfer.

That way they can collect interest on you as long as it takes for you to pay off the 0% offer. So if you do transfer your balance, be sure not to use the card for anything else. If you want to use it responsibly once the transfer is all paid off, go for it. But don’t touch it until then.

Can You Change It?

So, you ask, how can I make my payment apply where I want it to?

Because it’s in your agreement, you can’t force a company to apply your payments in a way that saves you money. They’re in the business of making money and you had the option of not using your card (or not accruing multiple balances).

However, this isn’t a reason to give up. You can still call the company and ask about your options. There may be a special way of marking your payments (this is common with student and car loans). Or you may be best off transferring your card’s entire balance to a 0% APR or low-interest card and doing it right this time (not making new charges and paying it all off in time). Once you’ve transferred it to a new card, all the charges are equal.

But the best thing is not to get yourself into this circumstance to begin with. Either pay off your whole card every month or use it in such a way that you don’t have a high-interest balance just sitting around accruing interest because you can’t pay it off.

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Francois July 28, 2008 at 12:06 pm

Good post.

I agree with you that it is possible to use your credit card responsibly. The most important thing I think is to ALWAYS pay the outstanding amount in full at the end of each month.

But be careful! Credit cards can be real financial monsters! I wrote a post about it a few days ago:

Dad July 28, 2008 at 6:00 pm

This is so true. From what I’ve seen most card users don’t know about this. If they don’t follow the billing statements carefully, they may not even notice what is happening.

As another blog said about this, if you use a card with a special balance transfer rate, DO NOT USE the card for ANYTHING else. He said, he would cut up the card to avoid mistakes. One purchase made by mistake can earn a lot of interest for the bank until you pay off the 0% APR balance.

BTW, this is nothing new. My first mastercharge card in 1968 had this same provision. The borrower needs to watch out for his or her own situation.

Funny about Money July 29, 2008 at 9:11 am

Wow! Nice piece of writing!

The way credit card issuers charge interest is so arcane as to be almost incomprehensible. I ran into this the single time I accidentally ran a balance on a Visa card (don’t recall why…I probably wrote the wrong amount on a check, or it got there late). It was almost impossible to get rid of the lingering interest rip-off. They were charging interest so that it continued to rack up between the time they sent the bill and the time they got my payment, so there was no way for me to pay it off. Then new charges would accrue interest at the same rate. Finally I had to stop charging, send them the entire amount of the balance plus a hundred bucks to more than cover whatever cockamamie charge they were levying, close the account, and demand they return the overage.

Even if you’re in the habit of paying your credit card every month, there always is the risk you’ll make a mistake, to the unreasonable profit of the issuer. I still use credit cards for their convenience…but you surely do have to be very careful.

Mrs. Nathan July 29, 2008 at 10:24 am

This is good to know – Nathan and I just signed up for a credit card through my parents’ credit union, so we’ll soon have to think about this.

Looking forward to seeing you next week!

Javier S. April 27, 2011 at 1:15 pm

This information is no longer accurate. The FED forced the credit companies to change the payment allocation methods and now if you make a payment the one with the highest interest rate will be paid off first leaving the one with the lowest interest rate. The law is now effective since Feb 22, 2010.

No matter the T&C on your statement you can still rely on the fact that you are protected by this new Law.

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