American households have more than $820 billion in credit card balances, according to the Federal Reserve Bank of New York’s Household Debt and Credit Report from Q2 2020.
One possible reason for this is a general lack of understanding about how credit card interest works. The same report found that 21% of Americans don’t know if they have any credit card debt and 30% are unaware of how much they pay in interest each month.
However, high annual percentage rates (APRs) and compounding interest make credit card debt incredibly risky. In this article, we explain what credit card interest is, how it works, and how you can get out of debt.
Defining credit card interest
Every credit card has a defined APR, which is the interest rate plus other fees. Simply put, the interest rate is the price of borrowing money from your credit card issuer.
Most credit card interest rates range between 18% and 25%. However, credit card companies may charge different interest rates depending on specific circumstances. Some different types of APRs include:
- Purchase APR: This is the standard APR assigned for credit card purchases.
- Promotional APR: This is a limited-time interest rate a credit card company may offer when you open a new account or during the holidays for new purchases.
- Deferred APR: A type of promotional APR where interest is deferred for a specified period.
- Balance transfer APR: This APR is charged when you move your outstanding balances from multiple credit cards onto one single balance transfer card.
- Cash advance APR: Using your credit card to withdraw cash triggers this type of APR. Typically, the cash advance interest rate is higher than the purchase APR. There may also be a cash advance fee.
- Penalty APR: If you break the terms of your credit card agreement, such as missing monthly payments, your issuer will charge a higher interest rate. You may also be subject to late fees and other penalties.
- Variable APR: This means the APR on your credit card can change over time. Credit card issuers have the right to make changes to your APR (either positive or negative). They must give you advanced notice before doing so. Most cards have variable interest rates.
How credit card interest works
APRs are expressed as annual rates. However, interest charges compound. Credit card companies use the average daily rate to determine how much you owe at the end of the billing period.
Let’s say you have a credit card with a 30-day billing cycle and have an average daily balance of $1,500 with a purchase APR of 15.99%
Calculating your interest is not as simple as multiplying $1,500 by 15.99% because credit card interest compounds. You are charged daily interest, and that interest builds on itself. Your interest is based on the principal, plus the interest from the previous day.
To see how this works, start by dividing your APR (15.99%) by the number of days in the year (365). This will yield your daily periodic rate. In this case, it’s .00044. Then, multiply your daily periodic rate by your average daily balance of $1,500. This yields a number of $0.66.
Finally, multiply your daily interest by the number of days in your billing cycle. In our example, $.66 x 30 = $19.80. This is the amount of interest you’re charged for this statement period.
Add this interest figure to your unpaid balance to calculate the amount you owe. You can find the full balance you owe on your credit card statement each month.
Paying your credit card bill
When you view your credit card statement, you’ll see different types of balances, including:
- Statement balance: This is the amount you owe at the end of your last billing cycle. If you do not pay this entire balance by the due date, you’ll begin collecting interest. Cardholders are required to have at least a 21-day grace period between the purchase date and the payment due date before charging interest.
- Current balance: This is the amount you currently owe. It’s a sum of your balance from the previous month, plus any new credit card purchases, minus any credit card payments you’ve made.
- Minimum payment: The minimum amount you must pay each month. Failure to make your minimum payment on time will result in late fees and penalty APRs. Even if you make your minimum payment, you’re still charged interest on your unpaid balance.
The only way to remain interest-free is to pay your statement balance in full by the due date. You can connect your credit card account to your checking account and set up automatic payments to ensure you never miss a payment.
Calculating your minimum payment
The terms of your agreement will explain in detail how your credit card issuer calculates your minimum payment. Most issuers will have a minimum of either $15 or $25. Credit card companies also use a formula that requires the minimum due to be 2% of the statement balance, rounded down to the nearest dollar.
In our example above, 2% of your $1,500 balance is $30. Card issuers will charge you the highest minimum possible. Since $30 is greater than $25, your minimum payment will be $30. If you make the minimum payment, your outstanding balance will be $1,470.
Remember, if you do not pay in full, you’ll incur interest charges on your balance. If you continue to make purchases on your card, your average daily rate will continue to increase, resulting in higher interest charges.
Why your credit card interest rate matters
If you pay your full balance every month, your credit card interest rate doesn’t matter much since you won’t incur interest. Making timely payments and paying your balance in full allows you to build good credit.
Having a good credit score makes it easier to manage your personal finances. A good credit score grants you access to lower interest rates on things like a mortgage and car loan. It could also allow you to negotiate with your credit card company for a lower interest rate or waive your annual fee.
If you don’t pay your balance in full every month, it’s crucial to know your credit card’s interest rate. Since interest is charged on your unpaid balance on a daily basis, you can accrue debt quickly. The more debt you have, the higher your credit utilization ratio.
Your minimum payments due each month will increase as your balance increases, making it more challenging to make these payments on time. Once you miss a monthly payment, you’re immediately charged late fees and penalty APRs.
These things can lead to a bad credit history, making it more difficult to secure new credit.
In sum, your interest rate isn’t critical if you pay your balance in full every month. But if you can’t pay your balance in full every month, a low interest rate will help keep your debt more manageable.
Options to help pay off debt
If you have good credit, an effective debt management option is a credit card payoff app. For instance, Tally offers a low-interest line of credit and uses it to pay your credit cards in the most strategic way possible, using the principles of the debt avalanche method.
Instead of having to track multiple credit cards and due dates, you make a single payment to Tally. Using this type of app can help you reach your financial goals sooner, freeing up cash that you can use to start saving for retirement.
Other options to consider include:
You’ll need to have a FICO score of around 640 or better to be eligible for a balance transfer card. On the other hand, the debt avalanche and snowball methods are payoff options for everyone, no matter what your credit score is.
Get closer to being debt-free
Borrowing on credit is not free money. If you don’t pay your balance in full every month, you’ll start accruing interest.
Credit card interest is unique because it’s based on your average daily rate and compounds. The average daily rate is based on your balance. Your balance not only includes the purchases you’ve made, but the interest you’ve collected. Interest is charged on top of interest.
Understanding your APR, the terms of your credit card, and the details of your monthly statement are essential to knowing how credit card interest works. If you’re in debt but have good credit, consider using a credit card payoff app like Tally or a balance transfer card to help. If you don’t have great credit, consider the debt avalanche or debt snowball method to start paying off credit cards and gain the momentum you need to become debt-free.