How do credit card interest work?

Credit card interest is the cost of borrowing money from your issuer. But depending on how you use your card, you may never have to pay on it.

If you pay your balance in full in every billing cycle, you will never be charged any interest. But if you roll over your balance from month to month, interest will be included in the minimum amount you’ll have to pay to keep your account up to date.

Unlike installment loans, credit card interest can take many forms and is calculated using a unique formula. Whether you’ve had credit cards for years or are considering getting your first, here’s everything you need to know about credit card interest, including how to avoid it.

What is credit card interest?

The amount you pay in interest may vary depending on the type of credit account you have, the availability of collateral, and your creditworthiness.

For example, a mortgage loan usually has a much lower interest rate than an unsecured personal loan because if you default, the mortgage lender can foreclose the house and sell it to recoup their losses. With an unsecured personal loan, there is no collateral to withdraw.

With both installment loans and credit cards, interest is calculated as a percentage of the account balance. This percentage is recalculated on an annualized basis to give you the Annualized Percentage Rate (APR).

Credit card interest is different from other types of loan interest because although an annual interest rate may be attached to your account, this does not necessarily mean that you will pay it. Most credit cards offer a grace period between the date of issue and the date of payment, during which you can pay off the previous month’s balance without interest.

Credit cards also come with several different types of APR, depending on how you use your account.

How is credit card interest calculated?

Credit cards usually have variable interest rates that fluctuate based on the base rate. The prime rate is based on the federal funds rate set by the Federal Reserve and is the benchmark that lenders use to establish lines of credit and credit cards.

This means that your APR can go up and down over time. It’s also important to note that credit card issuers usually calculate how much interest you owe daily, not monthly.

To calculate how much interest you are actually paying on your credit card, you first need to convert the annual interest rate to a daily interest rate.

• To do this, credit card issuers divide your APR by 360 or 365.. For example, if you have a 20 percent annual interest rate, your daily periodic rate could be 0.0556 percent or 0.0548 percent, depending on which bank or credit union opened your account.
• You will then calculate your average daily balance. To do this, start with the unpaid balance for the previous reporting period (if applicable) and then add up your balance at the end of each day during the current reporting period. Combine them all and divide the sum by the number of days in the billing period to get the average daily balance.
• Once you have your average daily balance and daily periodic rate, multiply by two and then multiply the result by the number of days in your billing cycle..

How are credit card rates determined?

While some credit cards offer one annual interest rate for all approved cardholders, most offer a range of annual interest rates. The APR you receive depends on the type of credit card you apply for and your creditworthiness. If you have a brilliant credit history, a low debt-to-income ratio, and other favorable qualities, your chances of earning an APR at the bottom of the spectrum increase.

However, if your credit history has problems or debt payments take up a large portion of your gross monthly income, you may be able to get a higher interest rate.

Consumers with limited, fair or bad credit may not even qualify for some of the best credit cards available. Credit cards for these types of credit profiles usually carry higher annual interest rates. For example, the average card interest rate for people with bad credit as of October 19, 2022 is 27.84 percent per annum. In contrast, the national average is 18.79 percent.

How not to pay interest

While credit cards typically have higher interest rates than mortgages, student loans, car loans, and personal loans, one of the benefits of having a credit card is that you don’t have to pay any interest at all.

There are several ways to achieve this goal:

• Pay your bill on time and in fullA: Credit card purchases generally have a grace period of at least 21 days between the end of each billing cycle and the payment date for that period. If you pay off your balance in full every month by the due date, you will never pay a cent in interest.
• Take advantage of promotions 0 percent per annum: If you need to finance a large purchase or want to transfer your balance from another card, look for 0 percent APR credit cards and balance transfer credit cards that allow you to do this without interest. Just be aware that many balance transfer cards charge a balance transfer fee, so the process isn’t always completely free.
• Avoid transactions without a grace periodA: Cash advances are rarely a good idea because they are expensive—you’ll often pay a higher annual interest rate plus a cash advance fee—and there’s no grace period. Try to avoid them completely if possible. Also, avoid transferring your balance from another card unless you have a 0 percent APR introductory promotion that you can use.

APR types

While credit cards often only advertise one APR in their marketing materials, there can be up to four, depending on the card:

• Buy per annum: This is the percentage you pay for purchases made with your account. Purchase APRs generally don’t work if you don’t have a balance after the due date each month, so it’s best to pay your bill in full before then. Some cards offer an initial 0 percent annual rate on purchases over a set period, allowing you to make purchases and pay for them without interest, whether or not you roll over the balance from month to month. However, the APR on regular purchases will apply to any balance after the end of the promotional period.
• Annual balance transferA: Many credit cards allow you to transfer your balance from another card, often at an introductory 0 percent annual interest rate for a predetermined period. During this time, you can pay off the transferred balance without interest. However, after this period, regular annual balance transfer income, which usually reflects annual purchase income, takes effect. If you don’t have an initial 0% annual interest rate, balance transfers usually begin to earn interest immediately, with no grace period.
• Cash advance per annum: In addition to making purchases directly with the card, you can use it to withdraw cash from an ATM or bank teller. When you do this, interest will begin to accrue immediately based on the card’s cash advance rate, which is usually higher than the annual purchase amount.
• Penalties per annum: A penalty of an annual interest rate, often much higher than the annual interest rate for a card purchase, takes effect if you are at least 60 days late with your payment and your card issuer has given you at least 45 days’ written notice increase your rate. . You may also lose your grace period. If you have activated the penalty at the annual interest rate, it will remain in the account until you make timely payments within six months.

bottom line

When you learn more about how your credit card works and follow these tips, you’ll be able to make better use of its benefits while avoiding unnecessary interest.

Ben Luthi is a freelance writer specializing in credit cards and personal finance. He is passionate about helping people find clarity about their finances and take actionable steps to improve their lives.