You may be familiar with the concept that credit card companies charge interest on unpaid balances, but do you understand the specifics of how credit card interest is calculated? Credit card interest is based on an account’s average daily balance during the billing period and is compounded daily. It’s worth noting that paying the entire statement balance by the due date will often result in the waiving of interest charges. In this article, we will delve into the details of how credit card interest works, including the different types of credit card interest, factors that influence a credit card’s interest rate, and strategies for avoiding or minimizing interest charges.
What is credit card interest?
Credit card interest is a fee that is charged on unpaid balances on a credit card. When you make a purchase with a credit card, you are essentially borrowing money from the credit card company. If you do not pay the full balance on your credit card statement, you will be charged interest on the unpaid balance.
The interest is typically expressed as an annual percentage rate (APR), which is the interest rate on a credit card expressed on a yearly basis.
Though APR is expressed as an annual rate, credit card companies use it to calculate the interest charged during your monthly billing period.
So for example, you make a purchase of $100 with your credit card. You are given a grace period of 25 days to pay off the balance before interest is charged. If you pay off the full $100 balance before the grace period ends, you will not be charged any interest.
However, if you only pay $50 of the balance before the grace period ends, you will be charged interest on the remaining $50 balance. The interest rate on your credit card will determine how much interest you are charged. For example, if the APR on your credit card is 18%, you will be charged $0.73 in interest for the month (calculated as $50×18%/365*30 = $0.73).
If you continue to only pay the minimum payment each month and carry a balance on your credit card, you will accrue more and more interest charges each month. This can make it more difficult to pay off your credit card balance and can also affect your credit score. It is generally recommended to pay off the full balance on your credit card each month to avoid accruing interest charges.
Types of credit card interest
There are several types of credit card interest:
- Variable interest rates: These interest rates can change over time based on market conditions or the credit card company’s policies. The interest rate on a credit card with a variable rate will be based on an index or benchmark, such as the prime rate, and will be adjusted periodically. The credit card company will then add a margin, or a set percentage, to this rate to determine the interest rate it will charge you. When market rates are low, variable interest rates may be a good option as they can offer a lower initial interest rate. However, it is important to be aware that the interest rate on a variable rate credit card can increase over time.
- Fixed interest rates: These interest rates remain the same over the life of the credit card. A credit card with a fixed rate will have a consistent interest rate, regardless of market conditions.
- Promotional interest rates: Some credit cards offer promotional interest rates for a limited time, such as 0% APR for a certain number of months. These promotional rates may apply to purchases, balance transfers, or both.
- Other rates: Credit cards may have different interest rates for different types of transactions, such as cash advances or balance transfers. These rates may be higher than the interest rate for purchases.
How does credit card interest work?
After the close of a billing cycle you are given a grace period to pay off the balance before interest is charged. This grace period is at a minimum 21 days but can also be as high as 55 days, depending on the credit card company. As long as you aren’t carrying a balance from your previous cycle and you pay off the full balance on your credit card before the grace period ends, you will not be charged any interest.
However, if you do not pay off the full balance on your credit card before the grace period ends, the unpaid portion of the balance will be carried over to the next billing cycle, known as a revolving balance. This revolving balance will accrue interest, which will be charged on a monthly basis. The interest rate on your credit card will determine how much interest you are charged. It is important to pay off as much of the balance as possible each month to avoid accruing interest charges on the revolving balance.
Here’s an example to illustrate how a grace period works:
You make a purchase of $500 with your credit card on May 15.
Your billing cycle ends on May 31, and your payment is due on June 28.
As long as you are not carrying a balance from the previous cycle and you pay off the full $500 balance on or before June 28, you will not be charged any interest on your purchase.
However, if you only pay $250 of the balance before the due date, you will be charged interest on the remaining $250 balance. The interest rate on your credit card will determine how much interest you are charged. For example, if the interest rate on your credit card is 18%, you will be charged $3.6 in interest for the month (calculated as $250 x 18% / 365 x 30 = $3.6).
It is important to pay off as much of the balance as possible before the grace period ends to avoid accruing interest charges. If you are unable to pay off the full balance, it is a good idea to at least pay the minimum payment to avoid late fees and potentially damaging your credit score.
What determines a credit card’s interest rate?
There are several factors that can determine a credit card’s interest rate:
- Credit score: Credit card companies often use your credit score as an indicator of your creditworthiness. If you have a good credit score, you are more likely to be approved for a credit card with a lower interest rate.
- Type of credit card: Different types of credit cards, such as rewards credit cards or balance transfer credit cards, may have different interest rates.
- Federal interest rate: The Federal Reserve sets a benchmark interest rate, called the federal funds rate, which can affect the interest rates on credit cards.
- Credit card company’s policies: Each credit card company sets its own interest rates, based on its own policies and risk assessment.
When is credit card interest charged?
Credit card interest is typically charged on a monthly basis, on the unpaid balance on your credit card. If you pay off the full balance on your credit card before the grace period ends, you will not be charged any interest. If you only pay a portion of the balance, you will be charged interest on the unpaid balance.
Where can you find your credit card’s interest rates?
You can typically find the interest rates on your credit card in the credit card agreement or in the credit card statement. The credit card agreement should also disclose any fees that may be associated with the credit card, such as an annual fee or balance transfer fee.
How to calculate credit card interest (step by step)
To calculate credit card interest, you will need to know the following information:
- The average daily balance on your credit card
- The Annual Percentage Rate (APR) on your credit card
- The number of days in the billing period
- Calculate the daily APR on your credit card: To do this, divide the APR by 365 (the number of days in the year). For example, if your APR is 18%, then your daily periodic rate would be calculated as 0.18 / 365 = 0.00049.
- Calculate your average daily balance: To determine your average daily balance, start with the unpaid balance on your credit card statement and add or subtract individual charges as they appear on your statement for each date of the billing cycle. Add up each daily balance amount and divide it by the number of days in your credit card’s billing period. This will give you your average daily balance.
- Multiply your daily periodic rate by your average daily balance: Let’s say your average daily balance came out to $640. Using the daily periodic rate calculated in step 1 and the average daily balance, multiply the two values to get the daily interest charge. In this example, the calculation would be 0.00049 x $640 = $0.31.
- Multiply by the number of days in your billing cycle: To get the total interest charge for the billing period, multiply the value from step 3 by the number of days in your billing cycle. In this example, the calculation would be $0.31 x 30 = $9.30.
Here is the formula to calculate credit card interest:
Interest Charged = Average Daily Balance x Daily Periodic Rate (APR / 365 days) x Days in Billing Period
For example, if your average daily balance on your credit card is $1,000, the APR is 18%, and the number of days in the billing cycle is 30, the interest charged would be:
Interest = ($1,000 x (18% / 365)) x 30 days
= $0.49 x 30 days
= $14.79
How can you avoid or reduce credit card interest charges?
There are several ways you can avoid or reduce credit card interest charges:
- Pay off the full balance on your credit card before the grace period ends: If you pay off the full balance on your credit card before the grace period ends, you will not be charged any interest.
- Use a credit card with a low interest rate: If you are planning to carry a balance on your credit card, it may be beneficial to use a credit card with a low interest rate.
- Transfer your balance to a credit card with a promotional interest rate: Some credit cards offer promotional interest rates for balance transfers. This can be a good option if you have a high interest rate on your current credit card and want to save on interest charges.
- Make multiple payments per month: Making multiple payments per month can help reduce the unpaid balance on your credit card, which can result in lower interest charges.
- Pay more than the minimum payment: If you only pay the minimum payment on your credit card, you will likely accrue more interest charges over time. By paying more than the minimum payment, you can reduce the unpaid balance on your credit card and lower the amount of interest charged.
FAQ
What is 24% APR on a credit card?
APR stands for annual percentage rate, and it is the interest rate on a credit card expressed on a yearly basis. A credit card with an APR of 24% means that you will be charged 24% interest on your unpaid balance each year.
Is credit card interest monthly or yearly?
Credit card interest is typically charged on a monthly basis. The interest rate on a credit card is usually expressed as an annual percentage rate (APR), but it is applied to your unpaid balance on a monthly basis.
Do I get charged interest if I pay the minimum?
If you only pay the minimum payment on your credit card, you will be charged interest on the unpaid balance. The minimum payment is typically a small percentage of the unpaid balance, and it is designed to cover the interest charges and a portion of the unpaid balance.
What happens if I carry a balance on my credit card?
If you carry a balance on your credit card, you will be charged interest on the unpaid balance. The longer you carry an unpaid balance on your credit card, the more interest you will accrue. This can make it more difficult to pay off your credit card balance and can also affect your credit score. It is generally recommended to pay off the full balance on your credit card each month to avoid accruing interest charges.
