- How Interest Rate Works on Credit Cards
- The Different Types of Interest Rates
- How Interest Rate Affects Your Credit Card Payment
How does interest rate work on credit cards? It’s simple! We’ll show you how interest is calculated and what you can do to keep your rates low.
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How Interest Rate Works on Credit Cards
When you use a credit card, you are borrowing money from the card issuer. The issuer then charges you interest on the money you borrowed, which is called the annual percentage rate (APR). The APR is the cost of borrowing money, and it is expressed as a percentage.
The basics of credit card interest
When you carry a balance on your credit card from month to month, you’ll be charged interest on that balance. How much interest you pay depends on your annual percentage rate (APR).
Your APR is the interest rate determined by your credit card issuer, which is then increased by any additional amounts—such as fees or premiums—that may apply. The APR is generally a variable rate, which means it can change over time.
You’ll find your APR in the terms and conditions that come with your credit card offer, or you can call your issuer and ask.
Once you know your APR, it’s easy to calculate how much interest you’ll pay in a year. Just multiply the amount of your daily periodic rate by the number of days in the year (365 for a standard year), and then multiply that number by the amount of your average daily balance. (See below for more on average daily balance.)
For example, let’s say you have a $1,000 balance on your credit card with an 18% APR and you’re charged a $10 annual fee. Your daily periodic rate would be .049% ((18% + 10%) ÷ 365). If you don’t pay off your entire balance one month, and it carries over to the next month, you’ll be charged interest on that unpaid balance. Let’s say your average daily balance for the month was $1,000. To calculate the interest charges for the month, multiply $1,000 by .049% (.000049), which equals 49 cents. So in this example, you would pay 49 cents in interest for that one month ($1,000 x .000049 = $0.49).
If this sounds like a lot of math—and it can be if you’re trying to calculate interest charges for multiple cards—you’re in luck. Most credit card issuers will do this math for you and list it on your monthly statement under something called “interest charges.”
How to calculate credit card interest
There are two ways to calculate credit card interest, and the method your card issuer uses will affect how much interest you pay.
The first way to calculate interest is using the average daily balance method. With this method, your card issuer adds up all the charges on your account for the month and then divides that number by the number of days in the billing cycle. Then, they multiply that number by the number of days between billing cycles to get your average daily balance. They multiply your average daily balance by your APR to get your monthly interest charge.
The second way to calculate interest is using the adjusted balance method. With this method, your card issuer starts with your balance at the beginning of the billing cycle and subtracts any payments or credits you made during that billing cycle. They multiply that number by your APR and divide it by 365 to get your daily periodic rate. Then they multiply that number by the number of days in the billing cycle to get your monthly interest charge.
The advantage of the adjusted balance method is that it doesn’t charging you interest on purchases made during that billing cycle, as long as you pay them off before the due date. That means if you have a high balance one month and make a big payment before the due date, you could save on interest charges using this method.
How to avoid paying interest on your credit card
There are a couple of ways to avoid paying interest on your credit card.
One way is to pay off your entire balance every month before the due date. That way, you won’t be charged any interest.
Another way to avoid paying interest is to take advantage of a 0% APR introductory offer. Many credit cards offer 0% APR for a set period of time, usually 12-18 months. This means that you won’t be charged any interest on your balance for that introductory period. Just be sure to pay off your balance before the intro period ends, or you’ll be charged retroactive interest.
The Different Types of Interest Rates
annual percentage rate, or APR, is the amount of interest on your credit card balance that you’ll pay yearly. APR is generally a higher number than your card’s periodic, or monthly, interest rate. The periodic rate is a small percentage of your card’s balance that is charged each month. Your card’s terms and disclosures should list both the periodic rate and APR. Paying attention to both is important because your credit card company can raise your periodic rate, but your APR is locked in for the life of the card. variable rate, or variable APR, is the interest rate on your credit card that can fluctuate with the prime rate. The prime rate is the rate at which banks lend to their best customers. If the prime rate goes up, your variable APR will usually go up as well. If the prime rate goes down, your variable APR will usually go down too
Fixed interest rate
With a fixed interest rate, your interest rate will never change, no matter what happens in the market. That means your monthly payment will stay the same for the life of your loan, making budgeting a breeze. And if rates go up? You’ll still have the lowest rate around.
Variable interest rate
A variable interest rate is an interest rate that may change over time, typically in response to changes in the markets. Variable interest rates are often used for products like credit cards and adjustable-rate mortgages.
With a variable interest rate, your monthly payments may go up or down in response to changes in the market. For example, if you have a variable-rate credit card with an APR of 14%, and the prime rate goes up by 2%, your APR will increase to 16%.
Variable interest rates can be either fixed or tied to an index. A fixed variable rate means that your rate will only change if the issuer changes it. An indexed variable rate is tied to an external benchmark, such as the prime rate, so your rate will fluctuate along with the benchmark.
Variable rates can offer some advantages over fixed rates. For one, they may start out lower than fixed rates. This can help you save on interest charges in the short term. Additionally, if market rates decline, you may be able to enjoy lower monthly payments on your variable-rate products.
However, there are also some risks associated with variable-rate products. If market rates rise, your payments could become more expensive, which could make it difficult to keep up with your debt repayments. Additionally, indexed variable rates may include an adjustment period during which your rates will not change even if market rates do – meaning you could end up paying more than you would with a fixed-rate product if rates rise during that period.
Introductory interest rate
An introductory interest rate, also called a teaser rate, is a low interest rate that’s offered for a limited time when you open a new credit card account. After the intro period ends, the interest rate goes up.
Introductory rates are meant to entice new cardholders and get them to transfer balances from high-interest cards. If you carry a balance on your new card after the intro period ends, you’ll be charged interest at the higher rate, which can add up quickly.
To benefit from an introductory interest rate, pay your balance in full before the intro period ends. That way, you’ll avoid paying interest at the higher rate.
How Interest Rate Affects Your Credit Card Payment
The interest rate on your credit card can have a big impact on your monthly payment. If you have a high interest rate, your payment will be higher. If you have a low interest rate, your payment will be lower. If you have a 0% interest rate, your payment will be the same each month.
The minimum payment on your credit card is the lowest amount you can pay on your bill each month without being charged a fee. Your minimum payment is determined by your credit card issuer, and generally includes interest and fees owed, as well as a small percentage of your outstanding balance.
Paying only the minimum amount each month will result in significant interest charges over time and will take much longer to pay off your credit card balance. For this reason, it’s important to try to pay more than the minimum amount each month, if possible.
When you transfer a balance from one credit card to another, you’re essentially taking out a loan and using the new credit card as collateral. The loan is usually interest-free for a promotional period of time, which can range from several months to a year or more. After that, the interest rate on the loan will revert to the standard rate for purchases on the new credit card, which will likely be higher than the rate you were paying on your old card.
Credit card companies typically charge higher interest rates for cash advances than they do for purchases. That’s because cash advances are like short-term loans: You’re borrowing money that you will eventually have to pay back with interest.
The interest rate on a cash advance is usually different from the interest rate on purchases. It might be a flat fee or a higher percentage rate (e.g., 5% instead of the usual 2% or 3%). And there’s often no grace period for cash advances, so interest starts accruing right away.
For example, let’s say you have a credit card with an 18% APR and you take out a $100 cash advance. If you don’t repay the full $100 right away, you’ll start accruing interest on the $100 at 18% APR. That means you’ll owe the credit card company not only the $100, but also some additional amount in interest.