How Does Credit Card Interest Work?


 

One of the things you need to consider when getting a credit card 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.

The Secrets Of Credit Card APRs

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.

Terms & Conditions Are Important

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.

Appreciating Your 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

  • 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.
  •  Avoid making cash withdrawals and doing money transfers with your credit card.
  • 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.