How Does Credit Card Interest Work and What Happens Next?

Credit card interest represents the cost of borrowing money from a credit card issuer. This cost is typically expressed as an Annual Percentage Rate (APR), which is a standardized way to show the yearly rate of interest. Understanding how interest works is important for managing personal finances and making informed spending and repayment decisions.

Understanding Credit Card Interest

The Annual Percentage Rate (APR) is the yearly cost of borrowing funds from a credit card issuer. Many credit cards feature a variable APR, which can change based on an underlying index like the prime rate. In contrast, a fixed APR remains constant, though card issuers can still change it with prior notice, often due to missed payments.

Credit card companies convert the APR into a Daily Periodic Rate (DPR) to calculate interest on a day-to-day basis. The DPR is found by dividing the APR by 365, typically 365 days. This daily rate is then applied to the cardholder’s outstanding balance each day. This daily calculation results in compounding interest, where interest is added to the balance, and subsequent interest is calculated on the new, higher amount.

The most common method credit card companies use to calculate the principal balance on which interest is charged is the “average daily balance” method. To determine this, the card issuer sums the outstanding balance for each day in the billing cycle, then divides that total by the number of days in the cycle. This average daily balance is subsequently multiplied by the DPR and the number of days in the billing cycle to arrive at the total interest charge for the period.

Credit cards can have different types of interest rates depending on the transaction:
Purchase APR: Applies to everyday purchases.
Cash Advance APR: Typically higher, applies to money withdrawn from an ATM, often without a grace period.
Balance Transfer APR: Applies when debt is moved between cards; can be promotional or higher.
Introductory APR: A temporarily low or 0% rate for a set period.
Penalty APR: Triggered by late payments.

How Interest Accrues and Payments Apply

Many credit cards offer a “grace period,” during which new purchases do not incur interest charges. This grace period typically extends from the end of a billing cycle until the payment due date, usually around 21 to 30 days. To benefit from this, the cardholder must pay the entire previous statement balance in full by the due date.

If a cardholder carries a balance from a previous billing cycle, new purchases generally begin accruing interest immediately from the transaction date, eliminating the grace period. Cash advances and balance transfers typically do not have a grace period, with interest beginning to accrue from the day of the transaction.

Credit card companies determine minimum payments as either a small percentage of the outstanding balance (typically 1% to 4%) or a fixed dollar amount (such as $25 or $35), whichever is greater. This minimum payment often includes any accrued interest and fees. While making the minimum payment keeps the account in good standing and avoids late fees, it primarily covers interest and only a small portion of the principal balance.

Only making minimum payments significantly prolongs the time it takes to pay off debt, leading to substantially higher total interest charges. For example, a balance that could be paid off in a few months might take several years, incurring thousands of dollars in additional interest. This approach also keeps credit utilization high, which can negatively impact credit scores.

Under federal law, credit card issuers have discretion on how to apply the minimum payment across different balances if there are multiple types of balances with varying interest rates. Often, the minimum payment is applied to the balance with the lowest interest rate first. However, any payment amount made above the minimum must be applied to the highest interest rate balance first, then to other balances in descending order of their APRs.

Beyond Interest: Consequences of Non-Payment

Late or missed credit card payments trigger financial and credit-related consequences, starting with late fees. Credit card issuers charge a late fee if a payment is not received by the due date, ranging from about $30 to $41. These fees are added to the outstanding balance, increasing the amount owed.

A penalty APR is a significantly higher interest rate triggered if a payment is 60 days or more past due. Once applied, it can remain in effect for a minimum of six consecutive months, even if subsequent payments are made on time. Credit card issuers are generally required to provide a 45-day notice before a penalty APR takes effect.

Missed or late payments also have a substantial negative impact on a consumer’s credit score. Payment history is a primary factor, and a payment reported as 30 or more days late can significantly lower a credit score. This negative mark can remain on credit reports for up to seven years, making it more challenging to obtain new credit, loans, or even housing.

If payments continue to be missed, credit card issuers will initiate collection activities. If the debt remains unpaid, the issuer may eventually sell the debt to a third-party collection agency. At this point, the original account may be “charged off,” meaning the credit card company has deemed the debt uncollectible and written it off as a loss. Although charged off, the debt is still legally owed by the consumer, and the collection agency will pursue repayment.