Credit cards are an important financial tool for many people, but if you don’t understand how credit card interest works, you could land yourself in a heap of financial trouble. Today, we are going to get a better understanding of how credit card interest works and what credit card interest rates mean. If you want to know how credit card interest works, follow along to learn more.
What is credit card interest?
Credit card interest is a charge from a credit card for borrowing funds. Credit card interest is one of the ways credit card companies make money, in addition to fees and interchange charges for processing transactions.
Credit card companies only charge interest when you carry a balance from one statement period to the next. If you pay off your balance in full every month by the due date, you never have to pay interest on a credit card.
Because of how credit card interest works, you can use a credit card regularly to earn rewards, such as cash back or travel miles and points, and never pay any interest. In fact, if you do carry a balance and pay interest, rewards credit cards are likely not the best choice for you.
But knowing that you never have to pay interest is important. With the right mindset and consistent on-time payments of your full balance, you should see your credit score increase and never pay a cent in interest.
How do credit card companies charge interest
Credit card companies typically charge interest based on an annual interest rate called an annual percentage rate, or APR. You can find your credit card’s APR on the credit card website or recent documentation.
Credit card companies can change interest rates at any time based on your credit history and market interest rates. In the current rising interest rate environment, this means interest rates are likely to go up in the coming months.
Also keep in mind that credit cards may charge different interest rates for purchases, balance transfers, and cash advances. So depending on what makes up your credit card balance, you could be charged multiple interest rates on the same statement.
To get your monthly interest charge, follow this set of steps:
First, calculate the daily periodic rate for your credit card. Divide your APR by 365 to get your daily periodic rate.
For example, on a card with a 20% APR interest rate: .20/365 = .0005479
Next, multiply that interest rate by the number of days in your billing cycle. For a 30-day month following the example above, that would be .0005479*30 = .0164. This means you get charged 1.64% every month based on your average daily balance.
Finally, multiply that monthly interest rate by your average daily balance. If you had an average daily balance of $1,000, your monthly interest charge would be .0164 x $1,000 = $16.44.
But if you pay your balance in full, the total of your monthly interest will always be $0. Even if you had a balance for a portion of the month, you don’t pay interest if you pay the card off in full before the due date.
Remember that you may have a grace period before your payment is due. But don’t cut it too close or you risk a late payment, which results in both fees and a negative hit on your credit score.
Credit card interest rates vary
Credit card interest rates are one of the key ways credit card companies make money. Now you understand how to avoid interest by paying early and how interest is charged if you don’t. But if you are shopping around for a credit card, what interest rates are considered low and what interest rates are considered high?
On the very high end, I have never seen a credit card that charged more than 29.99% APR. This interest rate is usually a rate for low-credit borrowers or a penalty rate after missing payments.
On the low end, you may find some cards with interest rates below 10%. The lowest interest rate I remember seeing on a major credit card was around 8%.
The average interest rate for a credit card is likely to fall in the range of 12% to 25% for most credit cards and most applicants. While you may be tempted to chase a card with a low interest rate, remember that you only pay that interest rate when you don’t pay off your balance in full. I know we have said this more than once in this article, but it is such an important concept.
You can avoid interest charges 100%. All you have to do is pay off your bill on time. If you can’t pay it off, don’t put the charges on the credit card in the first place. Then you have nothing to worry about.
Now you know the answer to the big question. You know how credit card interest works. Those who understand interest can avoid paying it, and avoiding expensive credit card interest is key to long-term financial success.
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