One of the many ways credit card issuers make money is by charging you interest when you have a balance on your card.
To everyone’s surprise, credit card interest is anything but simple. Cue the “home alone” style shocked face. The rates you advertise are not exactly the same as what you are actually charged, and when you are charged can significantly affect the amount you owe. Oh, and interest rates can easily and frequently change after you sign up for a card.
fasten your seatbelt. Here’s everything you need to know about how credit card interest works.
How does credit card interest work?
Credit card interest is the amount you’ll be charged when you repay your credit card balance after the due date.
Whenever you use your card to make purchases, withdraw cash, or transfer your balance from another card, you incur credit card debt, but interest is not automatically charged. You will receive a monthly statement with the amount of debt you have taken on and the repayment period, usually after one month. If you pay off the debt balance before the due date, you will not pay interest. For each day after your due date, if you have any balance, you will be charged interest at the unique rate provided in your credit card agreement.
Interest charges are actually a supplement to your card balance. The card issuer adds a percentage of your balance (the credit card interest rate) to your total debt each day, increasing the total amount you owe. When you pay off your balance (whether it’s a one-time or incremental), the amount of interest added becomes smaller, and you don’t pay any interest on your $0 balance.
You will never owe interest on any charges you repay before your statement due date.but you Do Even if you make the minimum payment listed on your credit card statement, any balance you hold after the due date will also pay interest. (Minimum repayments allow you to waive late fees, not interest.)
How is credit card interest calculated?
Credit card interest is calculated based on your credit card balance and interest rate and is usually charged daily.
You will always see the interest rate expressed as an annual rate (APR). The percentage most commonly used by companies to calculate credit card interest is actually the daily or monthly recurring rate, but the U.S. Truth in Lending Act requires issuers to disclose APRs to ensure consistency among credit card companies. APR is the daily recurring rate multiplied by 365 or the monthly recurring rate multiplied by 12.
Interest is calculated using the balance for a given month or the average daily balance for a given month. This only applies if you carry a balance; if your balance is $0, you must repay the fee during the statement period by the due date without accruing interest.
Multiply the regular rate by your balance to calculate the amount of interest charged to you.
Here is an example:
Let’s say your credit card has an APR of 23.5%. This is based on a daily cyclical rate of 0.06437%. You start the month with a balance of $1,000, then make a purchase on the 10th for $250 and another purchase on the 20th for $250. So you hold a 10-day balance of $1,000, a 10-day balance of $1,250, and a balance of $1,500 for 10 days. Find the average daily balance like this:
((1,000 x 10) + (1,250 x 10) + (1,500 x 10)) / 30
The average daily balance is $1,250 with a daily recurring interest fee of $0.80. Applied over 30 days in the cycle, interest is charged at $24 per month.
When is credit card interest charged?
Daily or monthly credit card interest is charged on any balance on your credit card. If you have a $0 balance and pay back any fees by the due date, you will not pay interest.
Because of compounding, when you charge credit card interest is important. As you can see in the example above, the interest you accrue in one compounding cycle (daily or monthly) increases your balance, and the interest in the next cycle is applied to the entire new balance.So you pay interest on the charges on the card add interest you accrue.
Simply put: interest for interest – it can add up quickly.
How much interest you pay depends largely on when the interest is compounded. A 1% daily increase in your balance is quite different from a 1% monthly increase. That’s why your credit card rates are always expressed in APR – so you can quickly compare credit card rates without confusion.
However, your APR doesn’t tell you exactly how much interest you’ll be charged, as it depends on your balance when compounded. For example, if your interest is compounded monthly, you will be charged based on your total balance at the end of the month. However, if it is compounded daily, you will be charged based on your average daily balance, which may be lower if you make purchases or payments throughout the month.
Here’s some more math to show you how it works:
Let’s return your credit card with a 23.5% APR and a balance of $1,500. For daily compounding, you pay $24 for an average daily balance of $1,250.
Using monthly compounding of the same APR, your monthly recurring interest rate will be 1.96%, which you will pay once at the end of the period for a fee of $29.40.
How to Avoid or Reduce Credit Card Interest
To avoid or reduce credit card interest, you can pay off your balance in full, reduce your balance as much as possible, or get a lower interest rate.
To completely avoid credit card interest, you need to pay off the balance in full by the due date each month. If you do not have a balance, you will not be charged interest.
To reduce the interest you pay, repay as much of the balance as possible each month. The lower the balance you hold, the less interest you will pay, as interest is charged as a percentage of the balance.
If your APR is lower, you will also pay less interest. The interest rate credit card companies offer you usually depends on your credit score and payment history – the higher your score, the lower your interest rate. As your credit score improves, contact your credit card issuer to ask for a lower rate and look for prequalified offers from other creditors willing to offer you lower rates.
If you’re moving your credit card to get a lower interest rate, look for a card with a balance transfer option. This allows you to transfer any balance from the old card to the new card, so you accrue interest at a lower rate.
Types of Credit Card Interest Rates
Credit cards have a variety of interest rates, depending on the source of the balance. Your credit card agreement will list the rate for each balance. Types of interest rates include:
- Purchase APR: The most common interest rate, the APR on purchases is the interest rate charged on things you buy with your credit card.
- Cash Advance APR: This rate is charged for cash you withdraw using your credit card.
- Balance Transfer APR: This rate is charged on balance transfers, money you transfer from your old card to this card.
- Penalty APR: If you miss payments frequently, the card issuer may increase your interest rate for about six months.
- Sales price: Some cards have a promotional period where you pay a lower APR, as low as 0%, for 6 to 24 months. Any balance you hold after the promotional period will accrue interest at your regular rate.
Interest rates can be fixed or variable. The difference is as follows:
- Fixed rate: This rate is set based on your credit score and payment history. As these factors change, under the Credit Cards Act 2009, card issuers can change your rates after the first year as long as they give you 45 days’ notice. Flat rates on credit cards have been rare since the law went into effect.
- Variable rate: Variable rates are based on your credit score and payment history, but are also tied to the prime rate — the base rate that banks use to set rates based on the federal funds rate. This type of APR can change the prime rate at any time and fluctuate with your personal factors. Since 2009, nearly all credit cards have had variable rates.
Average credit card interest rate
According to the Federal Reserve’s October Consumer Credit Report, the average credit card interest rate for all accounts in the U.S. was 16.27% as of August 2022. The average interest on assessed interest accounts (accounts with balances) is 18.43%. These averages have been climbing steadily over the past few years, as have prime rates.
Frequently Asked Questions (FAQs) About Interest Rates
Below are answers to some of the most frequently asked questions about interest rates.
How can I find my credit card interest rate?
The best place to find your credit card APR is your most recent statement, which you can access in your account through the card issuer’s app or website. You can always see your original APR in your credit card agreement, but it may have changed since you signed up.
What if I have a balance on my credit card?
If you have a balance on your credit card, you will be charged interest based on your APR and the card’s compounding period. As long as you make the minimum payment listed on your credit card statement, you won’t be charged late fees, but you will continue to accrue interest on the outstanding balance.A balance on your credit card also means that you have less available credit beyond your credit limit, which limits your purchasing power and can affect your credit score.
What is the difference between interest and annual interest rate?
On a credit card, there is no real difference between the interest rate and the APR (Annual Interest Rate). Technically, interest rates can refer to daily or monthly recurring rates, not APRs, but it’s safe to say that when someone refers to credit card rates, they’re referring to APR. (This does not apply to mortgages and other installment loans, which include APR fees not included in the interest rate.)
Contributor Dana Miranda is a Certified Personal Finance® Educator who has written about work and money for publications including Forbes, The New York Times, CNBC, Insider, NextAdvisor, and Inc. Magazine.