![How does credit card interest work? All your questions, answered How does credit card interest work? All your questions, answered](https://i0.wp.com/content.fortune.com/wp-content/uploads/2023/09/Recommends_Credit_Card_Interest.jpg?fit=%2C&ssl=1)
Credit cards can be your lifesaver when you’re in financial trouble. But what about the interest that comes with it? Not so much.
Your card’s interest rate determines how much you pay for your credit card charges. It could be a lot or none at all, depending on how you use your card.
So how is credit card interest calculated? Here’s everything you need to know about why credit cards charge interest, how banks set interest rates, and how to avoid paying interest.
How does credit card interest work?
Credit card interest is a fee you pay when you have a balance on your credit card from one billing cycle to the next.
“A credit card is a loan product,” explains Karl Kaluza, vice president of marketing and communications for Member Access Processing (MAP), the largest aggregator of Visa card services for credit unions in the United States. “When consumers use a credit card to make a purchase, they are obtaining a loan from the bank or credit union that issued the credit card they are using.”
Credit card interest rates are variable, which means they can move up or down based on changing market conditions. The interest rate is usually based on the prime rate (the rate a financial institution charges its best customers) plus a margin.
Understanding Interest Rates and Annual Percentage Rate (APR)
The terms “interest rate” and “annual percentage rate” are often used interchangeably when referring to charges incurred on credit card balances. Although the two terms technically refer to slightly different concepts, they are essentially the same thing when it comes to your card.
Generally speaking, interest rates represent the cost of borrowing money. In the case of credit cards, the interest rate is the cost of carrying a balance. It is expressed as a percentage of the principal balance and does not include any fees or other charges.
In most cases, the APR is a more comprehensive measure of the cost of borrowing money over one year. It includes the interest rate as well as any additional fees. For example, if you apply for a mortgage, you’ll typically need to pay closing costs and other fees upfront, adding to the overall cost of the loan. Therefore, the APR represents the actual cost of borrowing after taking these additional charges into account.
Credit cards may also charge annual fees, balance transfer fees, late payment fees, and more. However, there’s no way to accurately predict when a cardholder will incur these charges, so credit card companies simply factor interest into the APR. That’s why interest rates and APRs are essentially the same for credit cards.
Types of credit card annual interest rates
You may not realize it, but you can have multiple APRs associated with your credit card. Different types of APRs may apply to different situations. Here are the common types of credit card APRs you may encounter:
- Purchase annual interest rate: This is the interest rate that applies to purchases you make with your credit card. If you do not pay off the entire balance by the due date, you will be charged an APR on the purchase based on the unpaid balance.
- Annual interest rate introduction: Some credit cards offer lower APRs for a limited time to attract new customers. The length of the introductory period is determined by the card issuer, but generally, it lasts from 12 to 21 months. After the promotional period ends, the APR reverts to the standard purchase rate.
- Balance transfer APR: This is the interest rate that applies to any balance transferred from one credit card to another. Often, credit card companies offer low introductory balance transfer APRs to incentivize people to transfer their balances. However, balance transfers also typically come with a fee of around 3% to 5% of the transfer amount.
- Cash advance annual interest rate: This is the interest rate charged when you use your credit card to withdraw cash from an ATM or bank. “Interest rates on cash advances are typically much higher than the purchase APR, and interest usually starts accruing immediately, with no 30-day grace period,” Kaluza points out. Cash advances also often come with fees, which can be expressed as a flat rate or a percentage.
- Penalty annual interest rate: If you violate the terms of your credit card agreement (such as making a late payment or going over your credit limit), a higher interest rate applies. But the higher APR is not surprising. “Credit card issuers must disclose the conditions under which penalties may be charged,” Kaluza said.
What is considered a good credit card interest rate?
What is considered a “good” credit card interest rate really depends on what it is, especially considering that interest rates are variable.
“Good credit card APRs are at or below the national average,” says Ericka Wright, assistant vice president and branch manager. Additional Financial Credit Union.Currently, we are experiencing a rising interest rate environment, with average credit card interest rates hovering Slightly more than 21%. Therefore, any rate below this range would be considered pretty good, even though rates in this range would have been considered terrible 10 years ago.
In addition, your own personal credit and financial situation will also affect the interest rate you qualify for. “If your credit score is not as good, you may get a higher APR,” Wright said.
Credit card applicants with very good FICO scores (i.e. above 740) are considered ideal borrowers because they have demonstrated a history of borrowing money responsibly. Therefore, they will get the lowest price. On the other hand, people with scores below 670 are considered “subprime” borrowers and are at higher risk of not paying their bills on time or defaulting on their accounts. Therefore, to compensate for the higher risk, credit card companies may charge them a higher interest rate. (If you have poor credit, you may want to consider a secured card.)
The great thing about a credit card is that, unlike other types of financing, whether or not you pay interest is entirely up to you. Remember, you will only accrue interest if you carry a balance each month. “The best rate is 0% interest because the cardholder has paid off the entire balance within 30 days,” Kaluza said.
How to calculate credit card interest
Depending on the card, your interest may be calculated monthly or daily.
To calculate your monthly APR, divide your current APR by 12 (the number of months in the year). This will provide you with your recurring monthly rate. That number is then multiplied by your current balance to get your monthly APR.
For example, let’s say you have a credit card with a balance of $1,000 and an 18% APR. To get the monthly annual interest rate, divide 18% by 12, or 1.5%. Then multiply the $1,000 balance by 0.015. The result is $15, which is your expected interest charge for the month.
Or, to find your daily APR, first divide your APR by 365 (the number of days in a year). This will give you your daily periodic rate. Then multiply your current balance by that number.
Let’s use our previous example of a credit card balance of $1,000 with an annual interest rate of 18%. First, divide 18% by 365 to get the daily APR. The result is about 0.0493%. Then multiply your $1,000 balance by 0.000493. In this case, your daily recurring rate is $0.49.
Finally, to calculate your estimated monthly interest charges, multiply the daily periodic rate by the number of days in the billing cycle. Most credit cards have a 30-day billing cycle, which equates to $14.70 in monthly interest.
Tips for Minimizing Credit Card Interest Charges
Interest rates on credit cards are pretty high these days. Therefore, it is important to avoid arousing interest as much as possible.
- Pay the balance in full: The best way to avoid paying interest is to pay off your entire balance by the due date each billing cycle. If you have no balance, no interest will accrue.
- Shop around for the best APR: To be on the safe side, if you want to open a new credit card, it’s best to get quotes from multiple cards and choose the one with the lowest interest rate. This way, if you do have to carry a balance, you can lower your interest costs.
- Consider balance transfers: If you already have some credit card debt you want to pay off, consider transferring the balance to a credit card with a 0% APR discount. You can use your introductory period to pay off your balance faster because you won’t accrue additional interest and 100% of your payments will be applied to principal.
takeout
Kaluza said that if used correctly, a credit card is essentially a free 30-day loan. They can be a valuable financial tool, especially if you also earn rewards for your spending.
However, credit cards can be an expensive form of borrowing if you carry a monthly balance, since interest rates are typically higher than personal loans, home equity loans and other forms of financing.
So if you choose to pay by credit card, be sure to only charge what you can afford to repay when the due date arrives. If you end up with a larger balance, focus on eliminating that debt first before considering other low-interest loans to save money.
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