How Does the Interest on a Credit Card Work?
Understand the core mechanics of how credit card interest is charged and what factors truly influence your borrowing costs.
Credit cards offer a convenient way to access funds for purchases, but they also involve interest, which is the cost of borrowing money. This fee is charged by the lender for using their money and is typically applied when a balance is carried over from one billing cycle to the next.
Understanding Annual Percentage Rates
The Annual Percentage Rate, or APR, represents the yearly cost of borrowing money on a credit card, expressed as a percentage. This rate is a standardized way for lenders to communicate the interest cost to consumers. While it is an annual rate, credit card interest is calculated and applied frequently, often on a daily basis.
Credit cards can feature different types of APRs. The purchase APR applies to everyday purchases made with the card. A cash advance APR, which is often higher than the purchase APR, applies when you withdraw cash using your credit card. Balance transfer APRs apply to balances transferred from other credit accounts.
Some cards also include a penalty APR, which can be significantly higher than other rates and is activated if a cardholder misses a payment or violates other terms of the cardholder agreement. Each of these APRs dictates the rate at which interest will accrue on the corresponding type of balance.
How Interest is Calculated
Credit card interest is calculated using the Average Daily Balance method. This approach involves tracking the cardholder’s balance each day throughout the billing cycle. To determine the average daily balance, the balance for each day in the billing cycle is summed, and that total is divided by the number of days in the cycle.
Once the average daily balance is established, the Daily Periodic Rate (DPR) is applied. The DPR is derived by dividing the annual APR by the number of days in a year (365 or 360 days). For example, a 20% APR would translate to a daily rate of approximately 0.0548% (20% / 365). This daily rate is then multiplied by the average daily balance to determine the interest charged for that billing cycle.
Interest begins accruing on new purchases immediately if a previous balance was not paid in full by the due date. While interest is charged monthly, the calculation happens daily. This daily accrual means the longer a balance remains unpaid, the more interest will accumulate over time.
Key Factors in Interest Accumulation
Several practical elements and cardholder behaviors significantly influence the total interest paid on a credit card. The grace period is the time between the end of a billing cycle and the payment due date. During this period, interest is not charged on new purchases if the previous statement balance was paid in full by its due date. If the full balance is not paid, interest may be applied to new purchases from the transaction date.
Making only the minimum payment on a credit card can lead to substantial interest accumulation. While minimum payments keep an account in good standing, they often cover only a small portion of the principal and a larger portion of the accrued interest. This practice significantly extends the repayment period and increases the total interest paid over the life of the debt.
The way payments are applied to different balances also affects interest accumulation. Payments are applied first to balances with the highest APR, such as cash advances or penalty rate balances, before being applied to lower APR balances like purchases. This application method helps reduce the overall interest faster by targeting the most expensive debt first.