Credit cards, while exciting and useful, can land you into debt-trouble.
This is why it is essential to understand how credit card interest works.
What to know about credit card debt
Unfortunately, however, misusing a credit card can land you in a big pile of trouble, better known as debt.
Credit cards lend you money, but it comes at a cost. Data gathered by the Federal Reserve suggests that the total credit card debt in the US was at $790 billion at the end of the second quarter in 2021.
So, if you aren’t careful, you might end up paying a lot more than $2,500 for your $2,500 purchase.
Here’s what you need to know about how credit card interest works.
What is credit card interest?
Every credit card comes with an interest rate, i.e., the price you’ll pay for borrowing money, which is expressed as an annual percentage rate or APR.
This rate varies from card to card and person to person, depending on various factors.
It is calculated daily and charged at the end of your monthly billing cycle; however, these charges are usually waived if you pay your entire statement balance by its due date.
What is a billing cycle and a statement balance?
A billing cycle is the time frame between which two bills are generated. It records your spending and transactions generally over 30 days, after which the cycle resets.
At the end of each cycle, you are presented with a statement balance, which is the amount you owe for that particular period, along with a due date by which you should pay off the balance.
If you fail to pay your balance by the due date, you are charged interest on the amount you owe. As you carry your balance from month to month, your interest charges and debt continue to grow.
Different types of interest
The amount of interest you’ll pay depends on various factors, including:
- The interest rate or APR on your credit card
- The amount you spend
- When you spend it
- When you pay your credit card bill
There are many different types of interest rates, and learning about each of them can help you understand how credit card interest works.
When deciding which credit card to apply for, you must always compare different APRs to understand which one suits you best.
Credit cards can either have fixed or variable APR, usually depending on the credit card company.
A fixed APR generally remains unchanged and is less common with credit cards; they are more often associated with mortgages and personal loans.
Fixed APRs remain constant unless your payment is delayed by a large number of days or the card issuer sends a notice stating a change in rates.
The government mandates a notice of at least 45 days before increasing or changing the interest rates.
Variable APRs change over time and are calculated using the sum of a fixed index and an additional component added by the bank.
Many variable interest rates start with the prime rate, then add a marginal amount.
The different types of APR include:
This is a special rate granted for a short period, usually as a promotional practice to get you to sign up for a new credit card. The introductory APR is typically lower than the card’s regular APR.
This is the interest rate applied to purchases made on your credit card. You are only charged this rate when you fail to pay off the statement balance in total at the end of the month.
So, essentially you will not be charged if you pay off the balance before the due date.
Cash advance APR
This is the rate charged for cash withdrawal or a cash advance check on your credit card.
This rate is slightly different from the others because it’s charged right from the date of cash withdrawal, with no grace period. The interest rate here is also usually on the higher side, around 20-25%.
This is the highest interest percentage rate. If you pay your credit balance over 60 days late, you are charged interest at a rate significantly higher than your regular APR.
Usually, penalty APR applies for at least six months or longer if you continue to make late payments.
If you make timely payments for at least six months consecutively, the credit card issuer may reduce your interest rate.
Balance transfer APR
This is the interest on any balances you may choose to transfer to this credit card.
Often a credit card company will offer you a temporary promotional interest rate, sometimes as low as 0%, on the balance you owe on another card.
The motive here is to encourage you to transfer your balance from another card to this one, where you have the option to pay off the debt at a reduced rate of interest.
To sum it up, some credit cards charge different interest rates for different things. The interest rate charged on a purchase could vary vastly from the interest on a cash advance.
How is interest calculated?
Your credit card company or bank determines the interest rates for your credit card by checking your annual income and credit history.
This “hard check” on your credit history will show your creditors your credit score, payment history, and other valuable information regarding your creditworthiness.
The information then helps determine whether to issue you a credit card, what credit limit to allow you and what interest rates to charge you.
Higher credit scores usually equal lower interest rates.
Credit card interest puts most Americans in financial trouble simply because most of us don’t know how it works.
Ideally, as long as you pay off your statement balance in full within the due period, you won’t be paying any interest on your credit card.
Here’s how it works:
Let’s assume, at the end of a billing cycle; you owe $1,000. You don’t have to pay it all at once. Usually, you get at least 20 days between when the cycle ends and the final due date, and you can pay it off in smaller amounts during this period.
However, if you don’t pay the entire $1,000 before the end of this period, you are charged an additional amount as interest that is added to your outstanding balance in the next cycle.
If you are unable to or choose not to pay off the statement balance month after month, your interest rate amount starts to add up.
Let’s consider an example assuming you didn’t pay your balance in full, and you now have a balance of $1,000 on your credit card that charges an interest rate of 20% APR.
- Your November 1st statement balance = $1,000
- November 10th: you spend $200 more
- November 20th: you spend $300 more
- November 29th: you spend $100 more
By November 31st, your total statement balance is at $1,600. Now, to calculate the interest rate, we need to identify our average daily balance, the number of days in our billing cycle, and our APR.
Take your total balance for each day of the month, and add them all together.
- Day 1-9: 1000*9 = 9,000
- Day 10-19: 1200*10 = 12,000
- Day 20-28: 1500*9 = 13,500
- Day 29-30: 1600*2 = 3,400
- We get the total balance of each day as $37,900
Divide this sum by 30 because there are 30 days in November to get your average daily balance.
Average daily balance = 37,900/30 = $1,263.33
Divide the interest rate of your credit card by 365 to get a daily interest rate. Assuming an interest rate of 20% in this case,
Daily interest rate = (20/100)/365 = 0.00055
Multiply your daily interest rate by your average daily balance.
0.00055*1,263.33 = $0.70
Multiply this number by 30, the number of days in your November billing cycle.
0.70*30 = $21 is the interest charged on your November balance.
How to reduce credit card interest
Now that you have understood how credit card interest works, it might be worth trying to avoid paying interest charges or at least minimizing the amount of interest you pay per billing cycle. So here are some things you can do:
- Pay the statement balance in full before the due date of each cycle to avoid paying any interest on your credit cards.
- If you can’t pay the entire statement balance, pay off as much as you can to reduce the sum you are charged interest on.
- Keep your average daily balance as low as possible to pay less interest. You can also do this by paying off debts periodically throughout the cycle.
Once you have your balance back at $0, it’s important to maintain good payment habits and to keep the interest in check.
Consistently paying your statement balance in full ensures a higher credit score, which in turn qualifies for lower interest rates.
Recap credit card interest
Whether you’re getting your first credit card or trying to build a stronger credit score, we might have a card for you that also offers great benefits.
If you’re looking for a company that cares about your interest rate charges and rewards you for your successful, timely balance payments, we invite you to apply for early access to Vital Card.
We are the credit card that pays you to share and spend responsibly.
“Household Debt and Credit Report,” Federal Reserve Bank of New York
“Annual Percentage Rate (APR)…,” Investopedia
“The Average Credit Card Balance Is $5,525…,” CreditCards.com
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.