Home » Financial Education » How Does Credit Card Interest Work?

How Does Credit Card Interest Work?

How Does Credit Card Interest Work?

*Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It may not have been reviewed, approved or otherwise endorsed by the credit card issuer. This site may be compensated through a credit card issuer partnership.

This article was last updated Jun 02, 2020. Terms and conditions may have changed. For the most accurate information, please consult the issuer website.

Credit card interest rates, also referred to as the annual percentage rate or APR, are used to calculate how much interest you’ll be charged if you carry a balance on your credit card from month to month.

According to a recent study by CompareCards, the average APR for new credit card accounts is 19.21%, with the average credit card offering a range of 15.58% to 22.83% – depending on your creditworthiness.

We break down what you need to know about credit card interest, including how it’s calculated, the different types of APRs and how you can avoid interest charges altogether.

Frequently used credit card interest terms

Here are some terms that are commonly used when discussing credit card interest:

APR. An APR, or annual percentage rate, is the interest you’re charged for borrowing money from a lender. In the case of credit cards, this is the interest you’ll be charged if you don’t pay your credit card balance in full each month.

Compound interest. Compound interest is interest calculated on the principal interest as well as the accrued interest. Many credit card issuers compound interest daily – meaning, interest is added to your original balance at the end of each day.

Daily periodic interest rate. The daily periodic interest rate, or DPR, is used to calculate interest by dividing the card’s APR by 360 or 365, depending on the credit card issuer.

Deferred interest. Some credit cards (most often store credit cards), charge deferred interest – meaning, if you take advantage a card’s 0% intro APR offer but don’t pay the balance in full by the end of the promotional period, you will be assessed interest charges at the standard rate from the date of purchase, until the balance is paid off.

Read: What is Deferred Interest?

Fixed APR. Unlike variable APRs, fixed APRs do not fluctuate with changes to an index. However, this doesn’t mean that your interest rate will never change, as a card issuer may increase your APR for a variety of reasons as long as you’re given 45 days’ notice.

Read: How to Find a Fixed Rate Credit Card

Grace period. A credit card grace period is the amount of time between the end of a billing cycle and when your bill is due. Grace periods vary by issuer, and typically range between 21 and 25 days. Again, to avoid paying interest charges entirely, pay off your balance before the grace period ends.

Variable APR. The majority of credit cards offer variable interest rates, which means that the card’s interest rate can fluctuate with changes to the index interest rate, such as the prime rate. So if the prime rate increases or decreases, so will your credit card’s interest rates.

How to calculate credit card interest

Calculating your credit card interest requires some math, but you can do so by following the three steps listed below.

Note, for our example, we used a credit card with a 20% variable APR, 30-day billing cycle and a $1,000 balance on the card each day.

1. Convert the annual interest rate to a daily rate. Because credit card interest is calculated on a daily – and not annual – basis, you should first convert the APR to a daily rate. To do this, divide your APR by 365.

For example: 20% / 365 = 0.055% daily interest rate

2. Calculate your average daily balance. This can be done by taking the total balance from each day of the billing cycle and dividing that by the total number of days in the billing cycle. Then, multiply that amount by the total number of days in the billing cycle:

For example, if you have a $1,000 balance each day of a 30-day billing cycle, your average daily balance will be $1,000.

3. Calculate the monthly finance charge. Multiply your average daily balance by the annual percentage rate and the number of days in your billing cycle, then divide that amount by 365 days.

For example: 0.055 daily interest rate x $1,000 average daily balance x 30 days = $16.50 in interest charges for one billing cycle, which will be added to your balance if you don’t pay if off during the grace period.

Types of interest

There are different types of interest rates based on the type of credit card transaction.

Purchase APR. This is the interest rate that applies to any unpaid portion of your credit card balance at the end of a billing cycle for purchases made using your card.

Balance Transfer APR. If you transfer a balance from one credit card to another, you may be subject to interest charges on the transferred amount. Most credit cards offer the same APR on balance transfers and purchases; however, some cards also charge balance transfer fees (typically 3% to 5% of the amount of each transfer).

Read: Best Balance Transfer Credit Cards

Intro APR. Some credit cards offer low or 0% intro APRs on purchases and/or balance transfers for a limited period of time. For example, if you sign up for a credit card with a 0% intro APR on purchases for 12 months, you won’t be charged interest on your balance for a year. Once the 12-month promotional period ends, any unpaid portion of your balance will be subject to interest charges at the regular purchase APR.

Cash Advance APR: If you withdraw cash from your credit card, that’s considered a cash advance. Cash advance APRs are often significantly higher than purchase and balance transfer APRs. Additionally, because there is often a cash advance fee and no grace period and interest starts accruing immediately, we recommend avoiding these types of transactions whenever possible.

Penalty APR: If you pay your credit card bill more than 60 days late, the issuer may penalize you by increasing your interest rate. The penalty APR is typically much higher than your regular APR and can be in effect indefinitely. However, you may be able to restore your regular purchase APR by making at least six consecutive on-time payments.

How to avoid interest charges

If you want to avoid paying interest altogether, here are a few things to keep in mind:

  • Pay your bill in full and on time. You can avoid interest charges by paying your balance in full each month within the card’s grace period. Autopay can be a helpful feature to streamline payments, and you can set up payment reminders.
  • Make frequent payments towards your balance. You can make periodic payments towards your bill prior to receiving your statement.This allows you to maintain a lower balance and subsequently reduces your average daily balance.
  • Pay at least the minimum due. If you’re unable to pay your balance in full each month, be sure to pay at least the minimum amount due. Not paying the minimum amount on time each month puts you at risk of being charged a penalty APR and late fee.
  • Use a 0% intro APR card. By signing up for a credit card with a 0% intro APR, you can avoid paying interest for a specified period of time. Just know that, if you don’t make at least the minimum payment each month, the 0% promotional period will end. Also, if you don’t pay your balance in full before the promotional period ends, you will incur interest charges on the remaining balance.

Recommended Posts: