How Does Interest Rate Work on Credit Cards?
Demystify credit card interest. Discover how rates are determined, how interest accrues, and practical methods to manage your borrowing expenses effectively.
Credit card interest represents the fee a credit card issuer charges for borrowing money. It is a cost applied to any unpaid balance that carries over from one billing cycle to the next. Understanding how this charge works is important for cardholders to manage their finances and make informed decisions about credit card usage and repayment.
Understanding Annual Percentage Rate (APR)
The Annual Percentage Rate (APR) is how credit card interest is expressed, representing the yearly cost of borrowing. While shown as an annual figure, interest is typically calculated daily. For credit cards, “interest rate” and “APR” are often used interchangeably, as the APR reflects the interest charged.
Credit card issuers determine an individual’s APR based on factors including their credit score and income level. A higher credit score indicates lower risk to the lender, resulting in a lower APR. Most credit cards feature a variable APR, meaning the rate can fluctuate over time in response to changes in an underlying index, such as the prime rate.
How Credit Card Interest is Calculated
To determine daily interest, the Annual Percentage Rate (APR) is converted into a Daily Periodic Rate (DPR) by dividing the APR by 365, or sometimes 360.
The most prevalent method for calculating interest charges is the Average Daily Balance (ADB) method. Under this method, the card issuer calculates the average daily balance by summing the outstanding balance for each day in the billing cycle and dividing by the number of days. This average daily balance is then multiplied by the daily periodic rate and the number of days in the billing cycle to arrive at the total interest charged. Interest can compound daily, meaning interest from one day is added to the principal balance, and the next day’s interest is calculated on this new, larger balance.
Types of Credit Card Interest Rates
Credit cards can carry different interest rates depending on the type of transaction.
- The purchase APR applies to purchases made with the card and when a balance is carried over.
- The cash advance APR applies when a cardholder obtains cash using their credit card. This rate is higher than the purchase APR and begins accruing interest immediately, often without a grace period.
- The balance transfer APR applies when debt from one credit card is moved to another.
- An introductory or promotional APR is a temporary low or 0% rate on new purchases or balance transfers for a set period. Once this period concludes, the standard purchase or balance transfer APR takes effect.
- A penalty APR, often significantly higher, may be imposed if a cardholder makes late payments or violates agreement terms. Federal regulations require a 45-day notice before a penalty APR is applied.
Strategies to Avoid Paying Interest
To avoid paying credit card interest, leverage the grace period. This period is between the end of your billing cycle and your payment due date. By paying your entire statement balance by the due date within this grace period, you can avoid interest charges on new purchases.
If an unpaid balance is carried from the previous billing cycle, the grace period may be lost, and interest could begin accruing on new purchases from the transaction date. Making multiple payments throughout the month, rather than a single payment, can help reduce the average daily balance, lowering the total interest accrued.
Utilizing credit cards with 0% introductory APR offers on purchases or balance transfers provides a temporary interest-free window to pay down debt. However, balance transfers incur a fee.