Millions of Americans borrow money every year, and I’d estimate the vast majority of them don’t understand how compounded interest works. Interest can be a powerful tool to earn money (as with investments) or a dangerous financial handicap.

So how much is that $1,000 purchase going to cost you?

$1,000 on a credit card with 23% interest would have a minimum monthly payment of about $20/month (2% of the balance). If you paid $20/month consistently (note that the minimum payment would go down as your balance did) until it was paid off, it would take you almost 13 years to pay it off and would cost you $3,347!

Yes, you can make more than the minimum payment, but the average family has over $8000 in credit card debt. With a minimum payment of $160 (2%) that $8000 in debt would cost $26,783 when paid off!

This isn’t about whether or not you should borrow money, but I hope you can see how dramatic these simple examples show the power of interest.

Just imagine if you always paid the minimum payment, which would go down slightly every month. You would take longer to pay off the debt, costing you even more in interest!

You may look at the examples above and think that you’re better off because your interest rate is lower or because you pay slightly more than the minimum payment. That may be true, but you are still paying huge amounts of interest over the course of the debt.

Considering most credit card purchases we make are probably impulse buys, those impulse purchases end up costing us an arm and a leg. Remember the interest next time you’re thinking of swiping that plastic.

You have to be careful with these offers as there are usually strings attached. Balance transfers usually carry a one time fee of 3-5% of the amount transferred, or a flat fee (whichever is greater). This fee ensures that your credit card company is going to make money no matter what.

Balance transfers are not always bad

Balance transfers and convenience checks are not always a bad idea. They can save you a lot of money in some instances, and should definitely be considered if you have balances with much higher interest rates you could transfer. So how do you make sure you’re getting a good deal?

Formula for calculating REAL balance transfer cost

To calculate whether the balance transfer will be a good deal, you have to look at several factors:

• The amount you are transferring
• Your current interest rate
• Your balance transfer interest rate
• The fee for transferring the balance

Let’s say for example you have a $2500 balance on a credit card at 10% interest and get a balance transfer check from another lender that offers 7% interest for 12 months, and has a 5% one-time fee. Is it a good deal? Let’s see…

1. Let’s calculate the one-time fee for the transfer: $2500×5% = $125
2. Now, calculate the interest we pay currently (per month) at 10%: $2500 x (0.10 / 12) = $20/month interest
3. How much will we pay in interest per month at 7%: $2500 x (0.07/12) = $14.50/month interest

So let’s look at the above scenario… At first, it seems like we might save money by dropping our interest rate from 10% to 7%. After looking at the offer in detail, we see we would only be saving $5.50/month in interest charges and it would cost us $125 in fees just to take the offer. Considering the offer is only fixed at 7% for one year, we would lose a substantial amount of money by taking the offer.

This is an extreme example, but you can see where I am going with it. Be careful when you consider using balance transfer offers or convenience checks. They are a profit center of the credit card companies and are usually not a good deal.

Your FICO score is a representation of your credit based on past debt. Lenders use your FICO score to help them determine whether to lend you money and what interest rate to charge. The lower your FICO score, typically the higher interest rate you will be charged on a loan or credit card.

You cannot have a FICO score if you do not borrow money. Your FICO score is only a representation of your ability to keep and pay on debt. It does not report on your net worth, income, or ability to pay bills such as rent or utilities.

Since the credit reporting agencies determine your FICO score based off information contained in your credit report, you should check your credit report at least annually to ensure the information is accurate. You are entitled by law to receive one FREE copy of your credit report from each of the three credit reporting agencies per year.

To get a copy of your free credit report online in minutes, visit www.annualcreditreport.com. Beware! They will try to sell you an upgraded report, or credit protection. You do not have to pay a dime for your report, and you can still view it instantly online. You are also not required to participate in any “free trials.” Say no to every “offer” and just get the actual report.

Look over your report in detail and make sure all of the information is accurate and that the accounts being reported are yours. Be sure to look for:

• Duplicated accounts
• Closed accounts that still show as open
• Accounts that are older than 7 years
• Accounts that you did not open or do not recognize

You can dispute any inaccurate information with the credit reporting agency directly (i.e. TransUnion). They then have 30 days to verify the information is accurate and respond, or remove/correct the inaccurate information. You are not required to specify a reason why it is inaccurate. The best way to dispute information is in writing, sent certified with delivery notification.

Derogatory information can stay on your credit report for 7 years. Bankruptcy stays on your report for 10 years.