Understanding Credit Card Interest

What is credit card interest?

In general, interest is the cost of borrowing money from a lender. It’s typically shown as an annual percentage rate (APR). Most credit cards have variable APRs, meaning they can increase or decrease based on factors like the prime rate.

For example, if the prime rate is 5%, and the credit card charges the prime rate plus 12%, your APR would be 17%. If the prime rate increases to 7%, your APR would be 19%. Currently, the average APR of credit cards is about 23.74%.

Some credit cards charge multiple interest rates, such as one for purchases, one for balance transfers, and one for cash advances.

How does credit card interest work?

You are only charged interest if you carry a balance on your credit card from month to month. In that case, the credit card company would charge interest on the unpaid balance and add that charge to your balance. This means that if you don’t pay off your balance in full for several months in a row, you’ll end up paying interest on your interest.

The credit card company will multiply the balance you carry each day by a daily interest rate and add it to what you owe. (The daily rate is your APR divided by 365).

What are the types of credit card interest?

As mentioned above, a credit card can actually have different types of interest at different rates. However, the first thing to mention is that across the board of borrowing, you can have either “fixed” or “variable” interest rates.

1. Fixed: These stay relatively constant from month to month. Loans and mortgages typically have fixed rates, so the monthly payment is the same for the life of the loan. This makes them easier to budget for and calculate how much you’ll end up paying in interest.

2. Variable: These rates are tied to an index interest rate. Whichever the benchmark is tied to, it will increase or decrease over time with the benchmark index. Credit cards typically have variable interest, though some personal loans do as well.

When it comes to credit cards in particular, common types of interest include:

1. Purchase rates: Charged on purchases made with the card when those purchases are carried into a new billing period. This is the most common type of APR.

2. Balance transfer rates: Charged to balances transferred from other accounts when a balance is carried. Many cards offer a 0% introductory period where there is no interest charged, sometimes for up to two years, but then it increases to even higher than the purchase rates.

3. Cash advance rates: Charged on cash advances. These are often much higher than purchase and balance transfer rates, and it’s not recommended to use a credit card for a cash advance.

4. Penalty rates: Charged in the event you don’t make your minimum payments on time. These are also typically very high, so it’s important to make at least the minimum monthly payment on time. Or, avoid cards that charge this all together.

How to calculate credit card interest?

To calculate your interest charged, first calculate your average daily balance, the number of days in your billing cycle, and your APR.

To calculate your daily balance, start with your balance on Day 1, including debt you carried over from the previous month. Then, calculate your balance for each day by adding the card’s balance at the start of the day, the day’s new charges, and any fees. Do this for each day and divide it by the number of days in the statement cycle.

To calculate your interest:

• Divide your APR by the number of days in a year
• Multiple the daily periodic rate by your outstanding balance
• Multiply this number by the number of days (30) in your billing cycle

For example, say your card has an APR of 18%. The daily rate would be 0.049%. If you had an outstanding balance of $500 on day one, you would incur $0.24 in interest that day. On day two, your balance would be $500.24. After 30 days, you would end up with a balance of $507.45.

While this may not seem like a lot, higher interest rates and/or higher balances means interest accrues at a higher rate. If you continue to carry a balance for several months in a row, interest accrued can add up quickly. For example, if your balance was $3,000, you’d accrue $44.70 in interest (at 18% APR). At the average of 23.74% APR, you’d accrue $59.09 in interest that first month.

Why pay your balance in full?

If you pay off your balance in full, you don’t accrue interest. This can save you hundreds or thousands of dollars each year.

In fact, paying off a credit card balance is like getting a guaranteed rate of return on your investment. If your APR is 20% and you pay off your balance completely, you’re guaranteed to save yourself 20% of that balance.

If you’re able to pay off your balance in full and avoid interest, you may have additional cash you can put in an emergency fund or investment so it can grow even more.

How to avoid paying credit card interest?

Credit card APR is not only confusing, but it can be expensive. It’s best to avoid it altogether, which is possible if you use your card responsibly.

The best way to avoid paying credit card interest is to pay your balance in full each month.

Or, if you can’t pay it in full, pay as much as you can so that you have the lowest balance possible.

Other ways include:

1. Take advantage of a 0% intro APR: If you have to make a larger purchase or are consolidating debt by transferring balances from one card to another, avoid interest by getting a card that has a 0% APR introductory period. Even if you carry a balance, you will not be charged interest during this period.
Keep in mind that balance transfers often have a fee, which is usually 3-5% of the transfer amount. And, you must pay off the balance before the intro period is over; otherwise, you’ll be charged regular interest on the outstanding balance.

2. Avoid cash advances: Cash advances not only charge a much higher APR, but they also have a fee, which is typically 5% or more of the advance amount.

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