How Credit Card Interest Works

Credit card interest is the fee charged by credit card issuers for borrowing money. Understanding how it works is important for consumers to manage their finances effectively. It impacts the total cost of purchases if balances are not paid in full.

Understanding Annual Percentage Rate (APR)

The Annual Percentage Rate (APR) represents the yearly cost of borrowing money on a credit card. It is expressed as a percentage and determines interest charges on outstanding balances. Many credit cards feature a variable APR, which fluctuates based on an underlying index like the prime rate. Some cards offer a fixed-rate APR, though these can still change with advance notice, often 45 days.

Different APRs apply to various transactions. The purchase APR is the standard rate for new purchases if a balance is carried over. Cash advance APRs are typically higher and apply when cash is withdrawn. Balance transfer APRs apply to debt moved from another credit account, sometimes with a low introductory rate.

A penalty APR, a higher rate, can be applied if account terms are violated, such as making late payments. Introductory APRs offer a reduced or 0% rate for a promotional period, often 6 to 18 months, before reverting to a standard rate.

How Interest Accrues

Credit card interest accrues daily, even though it is expressed as an annual percentage rate. To calculate daily interest, issuers determine a “daily periodic rate” (DPR). This rate is derived by dividing the Annual Percentage Rate (APR) by the number of days in a year, commonly 365 or 360. For example, a 16% APR results in a daily periodic rate of approximately 0.044%. This daily rate is then applied to the outstanding balance.

The most common calculation method is the “average daily balance” method. This involves summing the outstanding balance for each day within a billing cycle and dividing that total by the number of days in the cycle to find the average. Daily balances include new charges, payments, credits, or fees. The daily periodic rate is then multiplied by this average daily balance and the number of days in the billing cycle to determine the total interest charge.

Interest on credit cards compounds daily. This means interest calculated for one day is added to the principal balance, and the next day’s interest is calculated on this new, higher balance. While the effect of daily compounding might seem minor over a single day, it can significantly increase the total amount owed over time, especially when a balance is carried month to month.

When Interest Applies

Credit card interest charges apply primarily when a balance is carried over from one billing cycle to the next. Many credit cards offer a “grace period,” a window during which new purchases can be paid off without incurring interest. This grace period typically extends from the close of the billing cycle to the payment due date, usually lasting at least 21 days. To benefit, the cardholder must pay the entire statement balance in full by the due date.

The grace period does not apply to all transactions. Interest on cash advances typically accrues immediately from the transaction date, often at a higher APR and without a grace period. Balance transfers may also lack a grace period, with interest starting from the transfer date unless a specific introductory 0% APR offer is active.

If a cardholder fails to pay the full statement balance in a previous month, they may lose the grace period for new purchases, meaning interest accrues from the purchase date. Once the grace period is lost, interest continues to be charged on new purchases from their transaction date until the entire balance is paid in full for two consecutive billing cycles.

Federal law, the Fair Credit Billing Act, requires credit card statements be delivered at least 21 days before the payment due date if a grace period is offered. This provides cardholders sufficient time to make payments and avoid interest charges.