How does credit card interest work?

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In a Nutshell

If you carry a balance, your credit card's APR will be used to calculate how much interest you will pay on it, so it’s worth understanding this all-important number before you sign up.

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Between rewards programs and greater financial flexibility, credit cards have a lot to offer. But if you don’t know how credit card interest works, you’ll have a hard time maximizing your card’s benefits.

In an ideal world, you’d never miss a monthly payment or carry a balance on your credit cards. Many Americans, however, do carry a credit card balance from month to month. According to the Federal Reserve Bank of New York’s Household Debt and Credit Report from the first quarter of 2017, credit card balances stand at approximately $764 billion — a $15 billion decrease from the previous quarter, but still a long ways from zero.

So, what’s the problem with carrying a balance? In many cases, it boils down to three letters: APR.

Interest and APR: A simple definition

Most credit cards come with an interest rate. Simply put, this is the price you’ll pay for borrowing money.

“It’s really a fee for using someone else’s money,” explains Todd Christensen, director of education at Debt Reduction Services, a nonprofit debt management and credit counseling organization in Boise, Idaho. “Interest is like rent: The longer you pay interest, the more interest you pay — and at the very end, you get nothing back.”

For credit cards, interest is typically expressed as a yearly rate known as the annual percentage rate, or APR. Though APR is expressed as an annual rate, credit card companies use it to calculate the interest charged during your monthly statement period.

Different types of interest and APR

There are other details in your card’s fine print you should review to understand how much you could pay in fees if you’re not careful. Here’s what you need to know.

A credit card can either have a fixed APR or a variable APR. A fixed APR typically remains the same, but it can change in certain circumstances, such as if your payment is more than 60 days late or when an introductory offer expires. A variable APR usually changes with the prime rate, as published in the Wall Street Journal. Many variable interest rates start with the prime rate, then add a margin. The result is your variable APR.

Credit cards generally have several different types of APR you’ll want to look out for.

  • Purchase APR: The interest rate applied to purchases made with the card.
  • Balance transfer APR: The interest rate applied on the balance transferred from one credit card to another.
  • Cash advance APR: The interest rate applied to the amount of cash borrowed from your credit card. This tends to be higher and typically does not have a grace period. As the Consumer Financial Protection Bureau notes: “If you use your card to get a cash advance … generally you will start paying interest as of the date of the transaction.”
  • Introductory APR: The temporary promotional APR that some credit card companies offer to get you to sign up. This can apply to purchases and/or balance transfers for a limited time period, and is typically lower than the card’s regular APR — sometimes 0%.
  • Penalty APR: The interest charged when you make late payments or violate the card’s other terms and conditions. This is usually the highest APR, and it may be imposed when your payment is more than 60 days late.

The purchase APR will be used to calculate how much interest you will pay on an outstanding purchase balance, if you have one. If you have excellent credit (generally scores of 750 or higher), you may be more likely to qualify for a lower interest rate because a credit card company may consider you a lower-risk customer.

If you have fair or poor credit (generally scores between 550 and 699), you may get a higher interest rate if you are approved for the card. This means it’ll cost you more every time you carry a balance with your card, so be sure to pay off your balance on time and in full every month, if possible.

How to calculate your APR

To calculate how much interest you’ll be charged, you’ll need to know your average daily balance, the number of days in your billing cycle and your APR.

Let’s say you have a travel rewards credit card and an average daily purchase balance of $1,500 at the end of your 30-day billing cycle. You also have a variable purchase APR of 15.99%.

Here’s how to calculate your interest charge (numbers are approximate).

  1. Divide your APR by the number of days in the year.
    0.1599 / 365 = a 0.00044 daily periodic rate
  2. Multiply the daily periodic rate by your average daily balance.
    0.00044 x $1,500 = $0.66
  3. Multiply this number by the number of days (30) in your billing cycle.
    $0.66 x 30 = $19.80 interest charged for this billing cycle

The math requires some work, but the concept is simple: Carry a balance, and you’ll pay interest.

Credit card companies generally give you at least a 21-day grace period between the purchase date and when the payment is due. If you pay off your balance in full and don’t have any cash advances outstanding, you won’t be charged interest on new purchases made during this interval.

Even if you can’t pay off your balance in full, consider paying off as much as you can to avoid late fees and reduce the overall balance subject to interest. The minimum payment is typically up to 3% of the outstanding balance, but Christensen says cardholders should pay more than the minimum each month.

“If you pay the minimum payment, you’re only paying interest plus a tiny bit of what you owe on the card,” he says.

Bottom line

Before you sign up for any card, know the interest rates and whether they are fixed or variable, and understand the factors that can allow your credit card company to change it.

Note that introductory APR periods don’t last forever. Also, if you pay more than 60 days late, you could be subject to a penalty APR, meaning you’ll be charged higher interest for several months or longer. (The good news? If you make six consecutive on-time payments, your credit card company may be willing to adjust the rate.)

Paying on time is a good practice in general. Christensen says the best way to avoid high credit card interest in the first place is to pay off your balance in full and on time each month. He advises consumers to educate themselves about how credit cards truly work and not fall for the myth “that to build good credit you have to carry a balance.”