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How Does Credit Card Interest Work?

If you’ve been shopping around for a credit card, you might have already stumbled upon this mysterious creature called APR. Gaining a deep understanding of the credit card’s APR is essential if you want to get the most value from your card. We've summarized everything you need to know on your credit card interest rate:

You can trust the integrity of our unbiased, independent editorial staff. We may, however, receive compensation from the issuers of some products mentioned in this article. Our opinions are our own.

Carrying a credit card balance can be a massive impediment to financial health. However, there are 0% credit cards that allow you to pay down your debt without incurring interest within the introductory period.

As you can see from this FED Survey of Consumer Finances data chart, the age group that tends to carry the highest credit card balances is the 75 and older age group with $8,000 on average. This is closely followed by the 45 to 54 age group with an average of $7,670.

Credit Card Balance by Age

One of the things you need to consider when carrying a credit card balance is the interest rate.  It will affect the cost of carrying a balance on the card and perhaps you would want to minimize or eliminate this cost.

Have you ever wondered how the card companies come up with the rates?  Read on.

What is Credit Card APR?

If you’ve been shopping around for a credit card, you might have already stumbled upon this mysterious creature called APR.  Gaining a deep understanding of the credit card’s APR is essential if you want to get the most value from your card.  APR stands for Annual Percentage Rate and it stands for the total annual cost of the credit card on purchases and other transactions that the cardholder makes.  That basic definition is the only simple thing about it.

It might be surprising to know that your credit card may have several APRs.  There may be a particular APR for a new customer and a different one for balance transfer.  They may offer a promotional APR for a fixed period of time, another on cash transactions (local and international) versus purchases, etc.  Some APRs cover the basic administration costs, while others do not.

Moreover, your credit rating will probably affect the APR.  Card companies normally give lower costs to those who are financially healthier. However, there are a couple of ways to reduce the interest rate.

Are Credit Card Interest Rates Fixed?

Keep in mind that APRs are never fixed.  The terms and conditions of your credit card will likely carry a stipulation that provides for the circumstances of a rate rise.  So keep an eye on things like expiry dates of promotional APRs, late payment APRs, cash advance APRs, etc.  Lenders will have to give notice if they are planning to increase your APR so be aware of what that notice period is.

The main thing to remember is that the APR is what you pay in order to be able to use the card.  In almost every case, it will only be a base cost.  When you begin to use your card extensively, charges and other fees will add up to your balance.  Then, the card company will add interest and compound the balances, raising the effective interest rate you will end up paying.  So, if you are intending to carry a balance (by not paying off your total card bill each month), get to know your APR details.  Spend sufficient time understanding how the APR rates of your credit card will impact the total computation.

What is My Credit Card Interest Rate?

If your credit card discloses an annual percentage rate of, for example, 13%, it doesn’t mean they will charge you 13% interest once a year.  How you manage your account will dictate whether the effective interest would be higher or lower.  Interestingly, it could even be zero percent.  This is because they calculate the interest on a daily basis and not annually on the amount of debt you carry from month to month.

Card companies will give you a grace period during which you can pay your credit card balance in full so you can avoid paying interest.

If you leave any balance beyond the grace period, the company will charge you interest for it in the form of a finance charge.

Card companies do not compute the finance charges the same way so, read your credit card terms.  Some will use your average daily credit card balance as the basis while others will use your balance at either the beginning or end of your billing cycle.  The finance charges may or may not include recent purchases you make on your credit card.

How Do Credit Cards Companies Compute Your Interest Rate?

To calculate how much interest you’ll have to pay, you need to know your average daily balance, the number of days in your billing cycle and your APR.

For instance: you have a travel rewards credit card and you have an average daily purchase balance of $2,000 after your 30-day billing cycle.  Your card has a variable purchase APR of 18 percent.

This is how to calculate your interest charge (the numbers are approximate):

Step 1:   Divide the APR by the total number of days in the year

0.18/365 = 0.0004931 (daily periodic rate)

Step 2:  Multiply the daily periodic rate by your average daily balance

0.004931 x $2,000 = $0.98

Step 3:   Multiply this number by the number of days in the billing cycle

$0.98 X 30 = $29.40 (interest charges for this billing cycle)

You may find the math work a little complicated but the concept is plain and simple:  Carry a balance and you’ll have to pay interest.

Card companies charge different rates but generally, they fall between 1% and 3% per month (this is an APR of 12% to 36%).

Compute Your Interest Rate – More Examples

Second Example: Assume you have a balance of $1,000 at the beginning of the month and do not use your card afterward.  For that month alone, your charges will run between $10 and $30 for the $1,000 balance.  If you leave the card inactive for the entire year, you will end up paying between $120 and $360 in interest alone!

Please note that these figures are NOT what your minimum payment will be.  Your minimum payment will comprise of interest plus a small amount of the total sum that you owe.

Third example:  Supposing your credit card has an APR of 12% – it will have a daily rate of 0.032786%.  Let’s say that you have a balance of $1,000 at the 12% APR standard interest rate.  On Day 2, they will add interest your balance becomes $1,000.32, plus any new purchases and minus any new credits or payments.  This process happens every day until the end of your monthly statement cycle.  At the end of the month, your beginning balance of $1,000 will become $1010 when they apply interest charges using 12% APR.

Here are a few more important facts to remember:

  • Card companies use different interest rates and charges for cash advance balances and balance transfer amounts. Furthermore, they will impose a stiffer penalty interest rate if the cardholder fails to make the necessary payments.
  • The Prime Rate DO affect credit card variable interest rates. The Prime Rate is an interest rate that is three percentage points higher than the federal funds rate.  The federal funds rate is set by the Federal Reserve Bank.  Since this interest rate can increase, you should be careful not to incur more interest charges than you can comfortably afford each month.

How To Keep Your Interest Payments Down

1. Pay your outstanding balance on or before the due date. This is usually a minimum of 21-25 days or maximum of 52-56 days after the purchase.
2.  Avoid making cash withdrawals and doing money transfers with your credit card.
3. Maximize different offers of interest-free balance transfers on credit cards and move your debt around.

If you regularly pay your total outstanding balance by the due date, you won’t have to pay any interest on any purchases.  Some credit card companies extend their offers “up to 56 days interest-free.”

In much simpler English, it means if you buy something on the first day of the new cycle, you have that whole month and then another 25 days to pay it off without interest.

A cash withdrawal transaction using your credit card is very, very expensive! The interest rates for these withdrawals are higher than normal and there is no way to escape them.  On top of that, credit card companies collect a fee for the withdrawal ranging from 1.5% to 3%.  So, treat the cash out like a plague!

Consider Balance Transfer

Perhaps the best way of getting around interest charges is by moving your debt between credit cards.  Because of the steep competition among credit cards, many cards have interest-free balance transfer offers – use them to your advantage!  For example, if you have a $2,000 outstanding balance on a card, find another card that offers 5-6 months interest-free on balance transfers.

By moving your debt to the other card, you could save between $96 and $240.  Just be mindful of balance transfer fees for moving your balance between cards.  Yes, card companies do charge around 2-3% depending on the amount you are transferring and they can add up.  Sit down and do the math first – you may be pleasantly surprised to find that a balance transfer is still a better idea.

Different Types of APRs

A credit card's annual percentage rate (APR) might be fixed or variable. A fixed APR usually stays the same, but it can change in certain circumstances, such as if your payment is late for more than 60 days or if a promotional deal expires. According to the Wall Street Journal, a variable APR changes with the prime rate. Many variable interest rates begin with the prime rate, which is subsequently increased by a margin. Your variable APR is the end consequence.

There are various distinct sorts of APRs on credit cards that you should be aware of.

  • Purchase APR: The rate of interest charged on purchases made with the card.
  • Penalty APR: When you make late payments or break the card's other terms and conditions, you will be charged interest. This is normally the highest APR, and it may be applied if you are more than 60 days late on your payments.
  • Balance transfer APR: The interest rate charged on a balance transferred from one credit card to another is known as the balance transfer APR.
  • Cash advance APR: The interest rate you pay on the money you borrow using your credit card. This is usually more expensive and does not provide a grace period. “If you use your card to acquire a cash advance… you will normally start paying interest as of the date of the transaction,” according to the Consumer Financial Protection Bureau.
  • Introductory APR: Some credit card providers offer a special APR to entice you to sign up for their card. For a limited time, this can apply to purchases and/or debt transfers, and it's usually lower than the card's regular APR – occasionally even 0%.

Credit Card Interest For Late Payment – How It Works?

Your credit card payment will be considered late if it is received after the due date or it is less than the minimum amount due. In addition to incurring a late fee, you may also start to be charged a penalty rate. This is often a higher interest rate that is stated in the card terms and conditions. The interest will be calculated at the end of every day and this will be added to your card balance. The following day, the full balance including the previous day’s interest attracts interest again, compounding the interest.

Credit Card Interest FAQs

most credit card companies give you a grace period. If your credit card issuer offers a grace period, you will not be charged interest on purchases if you pay your entire balance before the due date each month.

If a cardholder does not pay the entire statement balance or makes a late payment, the cardholder has forfeited his or her grace period, and interest charges will normally appear on the next bill. However, cardholders should always review their cardmember agreement for account-specific information.

While it used to be tax deductible, the Tax Reform Act of 1986 stopped allowing tax deductions for consumers on their credit card interest payments. This means that your credit card interest is never tax deductible if you are an individual.

The exception to this is if you have a business card. However, the debt needs to relate to business activity. You will not be able to make personal expense purchases on your company credit card and then claim a deduction for the interest.

Most credit card issuers set a fixed rate for at least a set period. So, you may receive an introductory rate of 2% for the first six months and then the rate will increase.

Most card issuers set their rates as fixed rather than variable, but while this rate won’t fluctuate, if your circumstances change, such as you have missed payments or your credit score drops, the rate may increase.

Most credit card companies compound interest daily. This means the interest you’re charged each day becomes part of the balance that attracts interest on the next day.

However, if you pay your bill in full each month, the interest will not apply to your daily balance. This can help you to save a great deal in charges and fees.