Not knowing how credit card interest works can have serious consequences on your credit, especially if you are unable to make unexpected large monthly payments. However, by gaining some knowledge of how the process works, you can maximize the benefits and the rewards of credit card ownership.
Knowing how much interest you’ll be charged if you carry a balance, how you can avoid paying high credit card interest rates and being prepared to take advantage of any special interest rate features of a particular credit card can save you plenty. It can also help you manage your finances and assist you in establishing a solid credit foundation.
Start Learning How Credit Card Interest Works before You Apply
Don’t miss this one important step before you apply for a credit card. Taking just a few minutes to review the pricing disclosure available to you before you complete the application, can alert you to excessive interest rates or fees you might encounter while utilizing the card. On the positive side, you may find special balance transfer offers or 0% interest rate periods for new purchases.
That’s because credit card companies are required to disclose upfront the APR (annual percentage rate) it charges for all transactions, how the credit card interest is calculated and any fees associated with using the credit card. For instance, purchases, cash advances and balance transfers may each have their own APR and associated fees. The disclosure also spells out any special features, rewards, or interest rate promotions available on the credit card.
Additionally, you’ll discover which APR you can expect to receive if you are approved for the credit card. The stronger your credit history, the better chance you’ll have of qualifying for a card with a lower APR. Some credit cards offer one single APR for all applicants while other credit cards offer a higher APR for a customer with a lower credit score and a lower APR for a customer with a better credit score. In this case, the different APRs will be disclosed up front and the credit card company will issue your card with a corresponding APR based on your determined credit worthiness.
Reading the pricing disclosure before you apply for any credit card is a great way to start gathering information on how credit card interest rates work.
How Interest Rates are Calculated on the Credit Card Transactions You Make
Credit card annual interest rates are stated as an APR. The average credit card APR, according to Bankrate.com is currently at 16.82 percent. Although it is an annual percentage rate, the 16.82 percent is not charged to your account on an annual basis. It is usually calculated daily on the balance you carry over after making your monthly payment, and then it is charged monthly as long as you carry a balance.
You could calculate the amount of interest you’ll be charged by dividing the annual interest rate by 365 to determine a daily interest rate and then apply that rate to your daily balance for each day in your statement period. Unfortunately, it is not a simple calculation because some credit card companies use average daily balances and have different daily or monthly compound interest calculation periods.
Fortunately, you don’t have to be a math wizard to determine how much interest you’ll be charged in any given month because you can utilize one of several credit card interest calculators available online to calculate an estimate. The calculators are especially effective if you’re only making a minimum payment each statement period as they’ll illustrate how much your debt is actually costing you.
Double check your APR before using one of the calculators, as your credit card APR may change after you’ve been issued the card. Credit card APRs are tied to the Federal Prime Rate. This information is also disclosed in the credit card agreement, stating that the APR is a certain percentage rate above the Prime Rate.
If you pay off your statement balance prior to the due date, you will not incur any interest charges. If it is not possible to pay off the entire balance by the due date, making a payment that is at least more than the minimum required will reduce the amount of interest charged.
Beware that different types of credit card transactions incur different APRs and associated fees. Purchases are subject to the applicable APR when your balance is not paid off by the due date. Cash advances can come with extra fees and higher interest rates than purchases. Balance transfers from other credit cards may incur additional fees and yet a separate APR.
Once again, the specific interest rates and associated fees will be disclosed in the credit card agreement which is available to you even before you apply. If you’re planning on utilizing your card for transactions other than purchases, you’ll want to be aware of the associated costs.
Keeping the Cost of Credit Card Ownership under Control and Maximizing the Benefits
Although grasping completely how credit card interest works may be a bit daunting, just know that the best way to avoid paying interest on your credit cards is to never carry a balance. With that said, when emergencies arise or a large purchase is necessary, it’s good to know that there are alternatives to incurring high credit card interest charges. There are plenty of credit cards that offer 0% interest on purchases for a limited period of time. Some cards even offer the option to transfer balances from high interest credit cards to enjoy a limited 0% interest period to pay off the balance without incurring interest charges.
One of our top picks for cards offering a 0% initial APR is the Citi Double Cash Card. Not only do you receive 18 months of 0% interest on balance transfer from the date your account is opened, you earn 2% cash back on purchases: 1% when you buy plus 1% as you pay.
Another popular 0% interest card is the Chase Freedom Card. A large purchase can be paid off without incurring interest charges for the first 15 billing cycles. With 5% cash back on quarterly bonus categories and 1% cash back on all other purchases, the card delivers great value.
The Bottom Line
Now that you have a better idea of how credit card interest works, you can utilize this knowledge to avoid paying unexpected interest charges and fees on your current credit cards. You’ll want to access your credit card’s pricing disclosure (credit card agreement) and learn about your APR, fees, payment grace period and how credit card interest works on your existing card. There may even be interest rate offers you have overlooked such as special 0% interest periods for purchases or interest free balance transfers.
Knowing how credit card interest works can heighten your understanding of your existing cards to minimize any unexpected expense. It can also help you select new cards that align with your financial objectives.