How Does Credit Card Interest Work?

Posted by Frank Gogol

Have you ever wondered how credit card balances can grow so rapidly and sometimes get out of hand? How does credit card interest work? Or have you ever wondered how to compare credit cards to get the best interest rate?

Credit card companies charge you interest unless you pay your balance in full each month. So if you don’t pay off your balance in full the following month, you’ll end up paying interest on your interest.

If you carry a balance, your credit card’s APR will be used to calculate how much interest you will pay on it.

Below we take a closer look at how does credit card interest works and how you can reduce the interest you pay each month.

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Interest and APR

How does credit card interest work? Credit card interest is a charge that is applied to your account when you don’t pay your credit card bill in full each month. In an ideal world, you’d never miss a monthly payment or carry a balance on your credit cards. But in reality, many Americans do. If you’re carrying a credit card balance from month to month, it is worth understanding how your credit card interest is calculated.

Most credit cards come with an interest rate. This is the rate at which you’ll be charged for borrowing money.

Credit card interest is typically expressed as a yearly rate known as the annual percentage rate or APR. This number will vary from card to card and person to person depending on a variety of factors.

  • Fixed vs. variable APR – Most credit cards have variable APRs. This means the percentage of interest you are charged will fluctuate with a particular benchmark. The prime interest rate is often used as a benchmark. So, for example, if the prime rate is 4%, and your credit card charges the prime rate plus 12%, your APR will be 16%. If at any time, the prime rate changes to 4.2%, your APR will also increase by 0.2%.
  • Multiple interest rates – Some credit cards charge multiple interest rates. For example, they may charge one rate on purchases, but another (usually higher) one on cash advances. This means the APR varies by transaction type, and your overall APR will be a combination of these rates.
  • Personal factors – Your APR is influenced by your credit score. If you have a poor credit score, you might be charged more interest by any given credit card company.

Though APR is expressed as an annual rate, credit card companies use it to calculate the daily interest that accrues on your account. All of the daily interest amounts are added together and added to your monthly statement. 

The daily rate is your annual interest rate (the APR) divided by 365. Your interest charge per month is worked out by taking your current balance and multiplying it by the daily APR rate. That amount is then added to your bill.

How to Calculate APR

The first thing you need to do to calculate your APR is to find out what it is. You can do this by looking up the APR on your credit card. Take into account your credit card might use multiple interest rates.

If your APR is given in relation to the prime interest rate, you may have to look that up too. If your card APR is given as prime + 14%, you need to know the prime rate to calculate your APR. For example, in June 2020, the prime rate was 4.25%, so your APR would have been 18.25%. When the Federal government decreased the prime rate to 3.25% in July 2020, your APR would also have gone down to 17.25%.

Next, convert your APR to a daily interest rate. To do this, take the APR on your credit card and divide that amount by 365. To continue the example from above, an APR of 17.25% divided by 365 days would give you an interest rate of 0.04726% per day. The more decimal points you keep, the more accurate your calculation will be.

Interest is assessed on your average daily balance. Let us imagine that you had an average outstanding balance of $500 on each day of the month. To calculate how much interest you would be charged on any given day, take an outstanding balance and multiply it by the daily interest rate.

$500 x 0.0476% = $0.24 interest per day

This process continues until the end of the month. So you multiply this interest amount by the number of days in your billing cycle:

$0.24 x 30 = $7,09 interest per 30 day billing cycle

How to Avoid or Reduce Credit Card Interest Charges

You want to pay as little interest as possible on your outstanding credit balances. Here are a few tips to reduce the credit card interest you pay:

  • Pay your credit card bill in full – Interest is charged if you are carrying a credit card balance from month to month. If you pay your credit card bill in full in the allotted time, you will not have to pay interest on it.
  • Pay off as much as you can – If you can’t pay off your full balance, consider paying off as much as you can. The minimum payment is typically up to 3% of the outstanding balance. If you pay more than that you can often avoid late fees. Additionally, you reduce the overall balance that’s subject to interest. Anything you pay over your minimum payment minimum will further reduce your interest charges.
  • Make use of the grace period – During a grace period, you aren’t charged interest on new purchases. Make sure you know what grace periods you are eligible for and make use of them. If you pay off your balance in full and don’t have any cash advances outstanding, credit card companies generally give you a 21-day grace period between the purchase date and the payment due date. 

Different Types of Interest and APR

There are different types of interest rates and APRs to look out for.

The first is your introductory APR. An introductory APR is the temporary, promotional APR that some credit card companies offer to get you to sign up. This can apply to purchases and/or balance transfers for a limited time. It is typically lower than the card’s regular APR. Make sure you know when your introductory APR expires. 

Two other APRs you’ll find are the purchase APR and cash advance APR. The interest rate applied to purchases made with the card (purchase APR) might be different from the interest rate applied to the amount of cash borrowed from your credit card (cash advance APR).

If you make late payments or violate your credit card’s other terms and conditions, you might be subjected to a penalty APR. This is usually the highest APR.

Even if you have a fixed APR, this can change in certain circumstances, such as if your payment is more than 60 days late or when an introductory offer expires.

When Credit Card Interest Won’t Apply

If you pay off your balance in full and don’t have any cash advances outstanding, credit card companies generally give you a grace period. A grace period is a time between the end of your credit card’s billing cycle and the date your payment is due.

While most cards offer a grace period on purchases, not all do. It’s important to check your card’s terms and conditions to see if a grace period is available.

Grace periods typically cover only purchases and do not apply to cash advances.

Why You Might Get Charged Interest with No Balance

Even if you think you’ve paid your balance off in full and you don’t make any other purchases, interest might show up on your next statement. This is called residual interest.

Residual interest is interest that appears on your statement because you made your payment after the grace period. Make sure you know what your grace periods are and make all payments in full during that time to avoid paying interest.

Conclusion

How does credit card interest work? Your credit card’s APR will be used to calculate how much interest you will pay on it. 

The interest on most credit cards is variable and will change from time to time. Some cards have multiple interest rates, such as one for purchases and another for cash advances.

It is important to be aware of all of the details in your card’s fine print so you understand how much you could pay in interest every month.

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