Interest Rates 101
It's the Rosetta Stone of all lending. Here's how your interest rate is calculated and what can make it go up.
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The bold-faced numbers on the outside of the envelope ("0% Balance Transfer Rate!" "9.9% For Life!"; "12% Forever!"; "Really, REALLY Low Rates! Really!") don't tell the whole story.
There's a lot more to calculating a credit card's interest rate than the copywriters let on. And if you're currently carrying a balance on your credit card -- even just occasionally -- the interest rate is the key to controlling your debt. Here's a Fool's primer on this important measure:
All kinds of interest rates
The APR refers to the annual percentage rate of interest you are charged on your credit card. It's the same thing as your interest rate.
The Prime Rate is used by banks to set the benchmark interest rate for their loans. Most follow the average prime rate -- which has hovered in the 6% to 10% range in the last decade -- calculated by The Wall Street Journal. For example, a lender advertising a card with an APR of Prime + 5% is hawking a card carrying a 9.75% APR based on the recent prime rate.
A fixed rate or fixed APR refers to an interest rate that will not change until the issuer decides to change it. You'll also see lenders refer to a fixed APR as "fixed for life," though as we mentioned before, they can legally change the rate at any time whether you're alive or not. A general rule of thumb is to look for a fixed rate card when interest rates are on the rise.
A variable rate is tied to a certain index (such as the prime rate, T-Bills, LIBOR, etc.), and, as the name implies, varies depending on what direction the index goes. Are interest rates on their way down? Then a card with a variable interest rate usually makes the most sense. Some issuers offer a "variable rate for life" or "prime-for-life" card, which means that the rate will never go above the prime rate.
If you are trying to pay off a balance, most likely you are looking for a card that offers a teaser rate (or "special" rate, "promotional" rate, "limited-time-only" rate). It is simply the Very Special Interest Rate the lender is offering at that time. As with most teasers, there are time limits attached. Teaser and introductory rates are usually offered for both fixed rate and variable rate cards. In all promotional materials for cards carrying a teaser rate, you'll see reference to an "ongoing APR," as well. That is the interest rate you will be charged on balances once the introductory "teaser rate" period has ended.
A penalty rate, as the name implies, is the price you pay for irking your lender. Here are things that can trigger a higher interest rate on your credit card:
- Late payments: Even one late payment and you can kiss your low teaser rate goodbye. Paying your bill late is considered a violation of the terms of your contract with your lender. It's there in the fine print, and there's not much you can do about it. So be sure to be a prompt bill payer.
- Carrying too large of a balance on another credit card: Your creditor may look at your credit records every quarter to evaluate the amount of debt relative to the amount of your current income. One notice received by a Fool staffer stated that customers could not increase "significantly" the amount they spent on another unsecured card. It defined "significant" as $2,000 or more. Keep your eye on your rates if you plan to make any big purchases.
- Your bill-paying habits: Even if you aren't taking advantage of a teaser rate, you could be subject to a penalty rate of up to 32% by missing a few payments or paying late for a number of months.
- Defaulting on a loan -- any loan: If your lender sees you pay late or default on another loan, he can re-price your credit card account so that he won't lose his money, too.
- Nothing at all: Your lender has every right to raise your interest rate. Even the most attractive interest rate offers -- even ones that are fixed or fixed-for-life -- can go by the wayside. Lenders are legally required to give you just 15 days' notice of a rate change, however, most will give you 30 days' notice.
Fun with math
Once you've figured out your interest rate, you need to determine how your lender decides what balance he's applying it to. Most issuers charge interest based on the average daily balance, which is calculated by adding each month's daily balance and dividing that number by the number of days in the month.
The interest equation takes on labyrinthine proportions when you try to figure out whether or not it is based on one or two months of billing cycles -- the current and the previous. Look for the notice on your statement that reads "Method of computing the balance for purchases." Some lenders use an "adjusted balance" method where the previous month's payment is subtracted and the finance charge is based on the remaining balance. There's also the "two-cycle average daily balance method (including new purchases)." When the issuer uses the two-cycle method, he averages your balance over the prior and current month to come up with an "average daily balance" upon which interest will be charged.
If you pay off your bill in full, your lender probably gives you a grace period during which you do not accrue finance charges. (If he doesn't, we recommend dumping him and finding a credit card that offers at least a 20-day grace period, like The Motley Fool credit card. Wink, wink.) If you do not pay off your balance in its entirety for each billing period, however, you will accrue interest on new purchases from the day they are posted.
Interest rate extra credit
As we mentioned in "Finding The One," there are a few finer points to deciphering the best interest rates advertised. If you are paying down a balance on your card, watch for the following:
Minimum rates or APR floors.
Major caveat: Some issuers make your initial variable rate the minimum rate. For example, let's say you open a credit card with an APR of Prime + 5% (currently 9.75% APR) and you expect the prime rate to drop over the next year. It might say in the fine print that the rate is variable based on the prime rate, but that the minimum rate is 9.75%. That means the cardholder gets no advantage if rates fall, and only sees a true variable interest rate if rates rise. It's an all-around bad deal.
Index calculations for variable rates:
If you hold a card that calculates interest based on a variable rate, watch out for how the issuer calculates the prime rate upon which your interest is based. To set the index for their variable rate cards (which they will adjust monthly or quarterly), some issuers determine the average of the prime rate over the past three months. (Though they reserve the right to use any prime rate over the three-month period -- meaning they could choose a rate from the beginning of the quarter which could be significantly higher than today's prime rate.) Therefore, if rates are dropping they will be slow to adjust downward and if rates are rising they will be fast to adjust. Look for an issuer that adjusts the rate on a particular date -- instead of one that chooses a date at random (meaning they'll probably use the highest rate of the period).
Different rates for different transactions.
A balance transfer rate does not always apply to new purchases as well. We often advise people who transfer an existing balance to a low-rate card to simply put the card away and pay it down. Any new purchases on the card will be subject to a higher percentage rate -- usually in the double-digit range. And forget about paying off the new purchase before the old balance transfer. Lenders will first apply your payments to the balances that carry the lowest interest rate. (After all, they're not making much money by charging you 0% interest on something, right?) When those balances are down to zero, then your payments will be applied to the new, higher interest rate purchases.
Here's your homework, Fools. Take out your last credit card statement. Find out what interest rate you're being charged and then turn over your statement and read the fine print in light gray type that gives the details. If you currently carry a balance, see if your lender can lower your rate -- or shop around and see if you can find a card that can beat it. Class is dismissed.