How Does Credit Card Interest Work?
Lyle is a writer specializing in credit cards, travel rewards programs, and banking. His work has also appeared on MSN Money, USA Today, and Yahoo! Finance.
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For all the benefits that credit cards offer, there are also risks to using them. One of the most common ways people get into trouble is via credit card interest. You can end up paying lots of money to your card issuer if you're not careful, which is why it's so important to understand how credit card interest works.
What is credit card interest?
Credit card interest is simply the cost of borrowing money with a credit card. If you don't pay off the full statement balance by the due date, then the card issuer can charge you interest on the unpaid amount.
What makes credit cards different from loans is that you can avoid interest if you use your card correctly -- you just need to pay the statement balance by the due date.
Most card issuers give you an interest-free grace period from the date they put together your billing statement until the payment due date. By understanding how credit cards work, you can use your card for purchases and pay them off without incurring any interest. This only applies when you pay in full, though. If you don't, you lose that grace period, and your card issuer can start charging you interest on new purchases immediately. You'll have to pay in full for two billing cycles in a row to get that grace period back.
What is APR?
APR stands for "annual percentage rate," and it's the total cost you pay per year for borrowing money. Let's say, for instance, you have a credit card with an APR of 20%. Your balance is $1,000, and it stays that way for the entire year. That balance would incur $200 -- 20% of that $1,000 -- in interest charges.
That said, most credit cards have variable APRs, which are APRs that can change.
It's only with credit cards that APR and interest rate mean the same thing. With other types of financing, such as loans, the interest rate refers specifically to the fee the lender charges for borrowing money. The APR is the total yearly cost of borrowing money, so it includes the interest rate and any additional fees. A mortgage has an interest rate, but it can also have an origination fee and closing costs -- those would be included in the APR, so the APR would be a bit higher than the interest rate.
How to find your credit card's APR
Your credit card's APR is listed in your billing statement each month. You can also find this information in your online credit card account.
Keep in mind that credit cards can have multiple APRs, as the rate can change depending on promotional offers, penalties, and transaction types. Here are the most common types of credit card APRs:
- Balance transfer
- Cash advance
- Promotional (a lower introductory rate, such as those offered by 0% intro APR cards)
- Penalty (a higher APR that the card issuer can apply when your payment is late, usually by 60 days or longer, or for other violations of your cardholder agreement)
How is credit card interest calculated?
To calculate credit card interest, card issuers multiply the daily percentage rate by the balance. The daily percentage rate is the card's APR divided by 365. On a credit card with an 18.25% APR, the daily percentage rate would be 0.05%.
While calculation methods can vary by card issuer, the most common is multiplying the outstanding balance by the daily percentage rate each day, and then adding up the daily interest totals for the billing cycle.
Let's say you start with a $1,000 balance on a card with an 18.25% APR. The interest on the first day would be $1,000 multiplied by 0.05%, which is $0.50. On the next day, the interest charge would be $1,000.50 multiplied by 0.05%, and so on.
How do card issuers determine interest rate?
Card issuers use a variety of factors to determine a card's interest rate, including:
- The prime rate: This is the interest rate banks offer to borrowers with the best credit, and it's closely related to the benchmark interest rate set by the Federal Reserve.
- Creditworthiness: Your credit, income, and other financial details will affect your card's interest rate if it has a variable APR. With better credit, you'll likely qualify for a rate on the lower end of the card's APR range. And among cards with fixed APRs, the cards intended for more creditworthy applicants tend to have lower APRs.
- Type of credit card: A credit card's category and the benefits it offers can play a role in its interest rate. For example, card issuers may set higher interest rates on their top rewards credit cards.
Paying less credit card interest
The best approach with credit card interest is to avoid it entirely. Considering that credit card APRs are often 18% or higher, it doesn't make sense to keep a balance on your card. Fortunately, you won't have any interest charges if you pay in full every month.
If you currently have credit card debt, there are ways to reduce how much interest you pay. You can look for balance transfer cards that offer 0% intro APRs on balances you transfer over. And if that's not an option, you can also try calling your card issuer and negotiating a lower APR. Both methods are worth looking into so you can spend less money on credit card interest.