How Does Credit Card Interest Work?

Even though financial experts believe many consumers should avoid credit cards, these financial tools are still one of America's most popular payment methods. Indeed, more than half of Americans use credit cards to make daily purchases.

Perhaps the number-one reason why shopping with credit cards is so attractive is because it brings lots of additional benefits like rewards, cashback offers, and free miles.

However, you must use your credit card responsibly. If you don’t, shopping may become your worst nightmare, and interest payments can quickly get out of control.

Basically, credit card interest is the amount of money that a credit card company will charge you if you’re late paying back what you spend. If you pay your balance on time each month, a credit card company won’t charge you any interest on your purchases.

How Interest Works on a Credit Card

If you’ve borrowed money from banks or lenders, you know that your interest payment is expressed as an annual percentage rate or APR. This figure includes both interest and additional fees.

Unlike interest rates on car loans or personal loans, credit card interest is calculated and expressed differently. With credit cards, you need to know your APR and your outstanding balance to calculate credit card interest.

Credit Card Interest Rate and APR

When looking for a credit card, you’ll see that each card comes with charges expressed as an annual percentage rate, or APR.

The APR you’ll pay varies from provider to provider, and it depends on your credit score and your credit history how affordable an APR you’ll qualify for.

The higher your credit score is, the better the chances you’ll get a low interest rate. But even if you borrow money from your card, it doesn’t mean that the bank will charge you interest if you manage your money well.

Most providers will charge you interest only if you don’t pay off the full balance on your credit at the end of your billing cycle. Your company will calculate the unpaid debt and add it to your balance for the next month.

If you don’t pay this balance on time, you’ll start accumulating interest on your interest. The worst-case result of this is high credit card balances that become harder and harder to pay off, which can sometimes lead consumers to bankruptcy.

How Credit Card Interest Is Calculated

If you prefer shopping with your credit card, it’s always a smart choice to look for credit cards with a zero-interest introductory offer on purchases to avoid scenarios in which you end up with a huge balance on your account.

Of course, no credit card company will offer zero-interest purchases for an unlimited time; the best you can hope for is a six-month or one-year introductory offer.

Given that, you’ll need to learn how to calculate interest on your credit card. Although it might sound complicated, calculating credit card interest is actually quite simple.

Calculate daily APR on credit card

The first thing you should do is to calculate your daily rate. The daily rate is the number you get when you divide APR by 365 (the number of days in the year).

For example, if your APR is 15%, your daily rate will be 0.041%. Once you know the daily rate, you’ll be able to work out how much interest you’ll owe if you miss your payment deadline.

Check your daily balance

To calculate interest on a credit card, you’ll need to know your average daily balance over the billing period. You can do that by adding up all the unpaid balance from the billing period, then dividing that by the number of days in the period.

Multiply your current balance by your daily APR

The next step is to multiply your average daily balance by the daily rate. By doing so, you’ll work out your daily interest charge. This will be added to what you owe.

For example, let’s say you have an average daily balance of $1,000 on your account and a daily rate of 0.041%. This daily interest of $0.41 is added to your balance the next day, so the total balance becomes $1,000.41 after one day.

Now you can calculate the interest you owe for the whole year.

While this might appear minimal at first glance, if your interest is compounding, it can quickly get out of hand. That’s because the following day, the interest will be $1,000.41 multiplied by 0.041%, and so on until the end of the statement cycle.

Needless to say, what started off as a seemingly insignificant extra sum can quickly snowball into an amount of money that will come back to haunt you if you’re not careful.

How Credit Card Interest Works With Different APRs

Credit card companies offer either variable or fixed APR for credit cards. As the name implies, a fixed APR should theoretically stay the same for as long as you use your credit card. However, it can be changed in some circumstances.

For example, if you’re late with your payments for more than two months, a credit card company can change your rate. And when we say “change your rate,” we mean that the APR is going to get higher, not lower. In this case, properly calculating interest and avoiding putting yourself at a disadvantage is especially helpful.

Most companies usually offer a variable interest rate on credit cards. A variable APR fluctuates depending on the bank’s prime rate, which is usually calculated using the federal funds rate.

A credit card company will add a margin on the prime rate, which results in your variable APR. Of course, everyone will look for credit cards that offer minimum interest charges, but unfortunately that doesn’t mean everyone will be able to qualify for low rates.

Purchase APR

The purchase rate is the rate that a credit card company will charge you each time you use your card for a purchase. Interest charge on purchases depends on many factors, including the prime rate and your creditworthiness.

Currently, the average APR is 16%, and it usually comes with a grace period of 21 days.

Cash advance APR

A cash advance is an interest rate that applies each time you make a cash advance with your credit card. This differs from a purchase APR; it’s higher and it doesn’t come with a grace period.

Balance transfer APR

Understanding credit card interest means knowing all about different APRs, including interest for balance transfers. This applies to transfers you make from card to card. It usually comes with a grace period like purchase APR.

Introductory APR

Some companies offer introductory APR for purchases and balance transfers to encourage you to use their services. In the best scenario this will be 0%, and in some cases it will be significantly lower than a regular APR.

This promo period usually lasts six or 12 months, but some credit cards come with even longer-lasting introductory rates.

Penalty APR

The penalty APR is what your credit card company will charge you in case you don’t pay balances on time. You should avoid this at all costs.

How Credit Cards Calculate Interest

Before giving you a credit card, the credit card company will determine your monthly interest rate and your credit limit. Some companies offer the same rate for all customers, while others have an APR range. Based on your creditworthiness, the company will determine your personal APR.

Some companies have websites where you can check your monthly rate for free and see if the terms suit you. If the rate is too high, you can always step away without paying any fees.

But if you submit your credit card request, a credit card company will calculate monthly credit card interest by doing a hard pull on your account. In this way, the company can see your credit score, annual income, payments, and all other information that will help its experts decide whether you are eligible for the card or not.

Your credit score is a significant factor in determining how affordable your rate will be. Scores are usually organized into several categories (poor, average, good, very good, and excellent). People with good to excellent credit scores can qualify for lower rates than those with average scores.

Even with a poor credit score, you can still find reasonable credit card offers. You can use math to your advantage and quickly boost your credit score with a card like one of these ones, specifically designed to help those with lower scores.

After doing that for a while, you’ll be able to qualify for a more affordable APR with a different card in the future.

Most providers know that young people love using credit cards, but many of them don’t have a credit score. For this reason, some providers offer credit cards for people with no credit score, which are perfect for shopping and traveling on a budget.

When Does Interest Accrue on Credit Cards?

Most credit card providers won't charge you interest on your purchases if you don't carry a balance from month to month. That means you need to pay your balance on or before the due date. You also need to pay it in full.

You should also know that credit companies are required by law to give consumers at least a 21-day grace period. During this period, you have a zero-interest charge on purchases and balance transfers with your credit card. The grace period is the time between the end of your billing cycle and your due date.

Some of the best providers will give you a generous 25-day grace period. The interest rate during this period will apply, but if you make your payment on time and don't carry a balance, then the company will ignore the interest that accrued during that period.

Keep in mind that you can lose your grace period if you don't pay the entire balance by the due date. The credit card company will charge you interest on your balances and any other purchases you make during the new statement cycle.

How to Avoid Credit Card Interest

This question has one simple answer: pay your monthly balances in full and on time. Credit card companies offer at least a 21-day grace period, meaning that you’ll get zero interest on purchases and credit card transfers if you pay your outstanding balance.

Paying off your balance on time is the most effective solution if you want to avoid interest charged on a credit card. There are also some other things you can do to prevent or at least reduce interest rates.

If you cannot pay your balance in full, try to at least pay a portion of what you owe each month. Usually, the minimum amount to pay is 3%, but it’s better to pay much more than this minimum; you’ll quickly reduce your balance and lower your accrued interest.

Another option to avoid paying interest is to use credit cards with a 0% APR introductory rate. Some credit card companies offer cards with 12, 13, or even 15 months of 0% APR on purchases and credit card balances. There is a minimum payment that you are obliged to pay each month to keep the introductory rate.

After this period expires, you’ll get a regular APR, so it’s best to pay all that you owe before the expiration date.