How Is Interest Charged on a Credit Card?

Credit card interest is the cost of borrowing money when using a credit card. It is a fee charged by the credit card issuer when a balance is not paid in full by the due date. Understanding how this interest is charged, calculated, and applied is important for managing personal finances effectively.

Understanding Credit Card Interest Rates

Credit card interest rates are most commonly expressed as an Annual Percentage Rate (APR). The APR represents the yearly cost of borrowing money, though interest is calculated more frequently, often daily. Different types of transactions can be subject to different APRs.

The purchase APR applies to new purchases. A cash advance APR applies when cash is withdrawn, and interest on these transactions begins accruing immediately. Balance transfer APRs apply to funds moved from one credit account to another. These rates can sometimes be lower than purchase APRs, especially during promotional periods.

Some credit cards offer introductory APRs, which are promotional rates, often 0%, for a set period on new purchases or balance transfers. Once this period ends, the rate reverts to a standard APR. Penalty APRs can be applied if specific terms of the cardholder agreement are violated, such as making a late payment. This higher rate may apply to all existing balances and new transactions. Credit cards can also have variable APRs, which fluctuate based on an underlying index like the U.S. Prime Rate, or fixed APRs, which remain constant unless the issuer provides advance notice of a change.

Calculating Credit Card Interest

The calculation of credit card interest involves two main components: the Daily Periodic Rate (DPR) and the average daily balance. The DPR is derived by dividing the annual APR by the number of days in a year, typically 365 or 360. For example, if an APR is 18.25%, the DPR would be 0.1825 divided by 365, resulting in approximately 0.0005.

Issuers typically use the average daily balance method to determine the amount subject to interest charges. To find the average daily balance, the outstanding balance for each day of the billing cycle is summed, and this total is divided by the number of days in that billing cycle. Payments and credits made during the cycle reduce the daily balance, while new purchases increase it.

Once the average daily balance is determined, the interest charge for the billing cycle is calculated. This is done by multiplying the average daily balance by the DPR, and then by the number of days in the billing cycle. For instance, if the average daily balance is $1,000, the DPR is 0.0005, and the billing cycle has 30 days, the interest charge would be $1,000 0.0005 30, equaling $15. This calculated interest is then added to the account’s outstanding balance, contributing to the total amount due on the next statement.

When Interest Charges Apply

Interest charges on credit cards apply under specific conditions. For new purchases, a grace period exists, which is an interest-free period. This period spans at least 21 days from the statement date to the payment due date. If the entire statement balance from the previous billing cycle is paid in full by the due date, new purchases will not accrue interest.

However, carrying a balance from one month to the next causes the cardholder to lose this grace period. In such cases, new purchases begin accruing interest immediately from the transaction date. To regain the grace period, the full outstanding balance, including any interest accrued, must be paid in full for two consecutive billing cycles.

Transactions such as cash advances and balance transfers do not benefit from a grace period. Interest on these types of transactions begins to accrue immediately from the date they are posted to the account. This means there is no interest-free window for these activities, making them more costly if not repaid quickly.

Factors Affecting Your Interest Rate

Several factors influence the Annual Percentage Rate (APR) assigned to a credit card account. An individual’s creditworthiness, primarily reflected by their credit score, is a key factor. A higher credit score indicates a lower risk to lenders, which results in a more favorable, lower APR. Conversely, lower credit scores lead to higher APRs.

For credit cards with variable APRs, the U.S. Prime Rate plays a direct role. The Prime Rate is a benchmark interest rate used by banks, and variable credit card APRs are set as the Prime Rate plus a margin. Therefore, changes in the Prime Rate directly impact the variable APR on the credit card. When the Prime Rate increases, the credit card’s variable APR will also rise, and vice versa.

The type of credit card product also affects the interest rate. Different categories of cards, such as rewards cards, low-interest cards, or secured cards, are designed with varying APR ranges to suit different consumer needs and risk profiles. Individual credit card issuers have their own risk assessment models and pricing strategies. These internal policies contribute to the range of APRs offered across different financial institutions for similar credit products.