How Does Interest Work on Your Credit Card?
Credit cards seem to perform magic tricks with interest, but we’re giving you a behind-the-scenes look at how it works.
Contributing Writer at Tally
November 19, 2021
Using a credit card is simple and has some perks, such as rewards points and other benefits. However, there is a downside to these conveniences: interest.
Credit card companies make a large portion of their profits by charging users interest. Like many tricky financial topics, credit card interest is in-depth, with plenty of twists, turns, and detours.
Below, we’ll answer the question, "How does interest work?" We’ll also guide you through other aspects of credit card interest, including how to minimize and avoid interest altogether.
What is credit card interest?
When you swipe your credit card to pay for an item, you’re essentially borrowing money from the credit card company. The credit card interest is the fee the credit card company charges you for borrowing money to pay for an item.
Credit card interest is expressed as a percentage and is also referred to as the annual percentage rate (APR). Credit card interest rates are often variable, meaning they change periodically as the credit card company's prime rate fluctuates. The prime rate is indexed by the federal funds rate, which is the rate financial institutions charge each other for overnight loans.
The federal funds rate fluctuates with the financial well-being of the country. The Federal Open Market Committee (FOMC) — a part of the Federal Reserve System — sets the federal funds rate.
Credit cards often have two types of interest rates:
Cash advance APR
The purchase APR interest rate will apply for anything you used your card to purchase.
Cash advance APR, which is generally slightly higher than the purchase APR, applies only to withdrawals you make from an ATM using your credit card or at a bank with a convenience check from the credit card issuer. Because you're receiving cash, this is effectively a personal loan from your credit card company.
Many credit cards also charge a 3% to 5% fee for a cash advance.
When does the credit card company charge interest?
Credit card companies advertise interest as an annual interest rate but calculate it daily, using a daily periodic rate (DPR). The DPR is simply your APR divided by 365. So, if you have a 19.9% interest rate, your DPR would be 0.0545%.
Your credit card company will start charging this rate on any balance carried after the interest grace period. The interest grace period is the time frame in which the credit card company charges no interest to your account. It generally lasts for 21 days after your credit card statement is generated.
The exception to the interest grace period is if you carry a balance from month to month. In this case, you lose the 21-day grace period and begin accruing interest at the DPR immediately.
You won't see the interest applied to your credit card account until you receive your monthly billing statement. When this statement arrives, you'll see the accrued interest listed as a finance charge.
How much interest will you pay?
A credit card that you don't actively use but still carry a balance on is fairly simple to calculate interest for. In this instance, you only need to calculate your monthly interest rate, which is your APR divided by 12. Using the 19.9% example above, this would be 1.66%.
Now, you multiply your balance by the monthly interest rate. The result is what your interest charges will be that month.
For example, if you owe $2,000 on a 19.9% credit card, the monthly interest charges would be $33.20.
Calculating interest can get confusing on a credit card you use regularly. First, calculate your daily periodic rate. Then, determine your average daily balance. This is where things can get complex.
To find your average daily balance, calculate your balance throughout the month and how many days it was at each dollar amount.
For example, if you had a $2,000 balance for 20 days and then charged another $500 to the account and left it at that balance for the remaining ten days of the billing cycle, you must break the average daily balance down using those balances and the number of days at each balance.
So, if you had a $2,000 balance for 20 days:
Multiply $2,000 and 20 to get $40,000.
Then, multiply $2,500 by 10 to get $25,000.
Now determine the average daily balance by adding the two totals and dividing them by the number of days in the billing cycle, which is 30 in this instance. The total resulting average daily balance would be $2,142.86 ($65,000 / 30 = $2,166.67).
Now, multiply the average daily balance by the daily periodic rate of 0.0545% to get your daily interest charges of $1.18.
Finally, multiply the daily interest charges by the number of days in the billing cycle (30) to get the total interest for the month of $35.40.
What is compounding interest?
Like a savings account, credit cards have compounding interest, albeit reversed. This means when the credit card company applies interest charges to your account, the charges increase your principal balance in the following billing statement, and the credit card company charges interest on this higher balance.
This effectively means the credit card company is charging interest on your interest.
For example, if you have a $100 balance and make a $25 payment, your balance is $75. However, the credit card company then applies $10 in interest charges, bringing the balance to $85. You’d pay interest charges on the $85 balance in the next billing cycle, not $75.
Simple interest, which credit cards don't use, is when the lender charges interest only on the original principal balance.
How can you minimize or avoid interest?
Pay off the balance monthly
Suppose you use a credit card to cover your expenses and pay off the entire statement balance within the interest grace period. In that case, you won’t incur interest charges as long as you didn't carry a balance over from the previous billing cycle.
For example, if you knew you were getting a $1,000 bonus this month and wanted to buy a $1,000 television now, you could put it on the credit card and pay the $1,000 off once you received your bonus. In this case, you wouldn’t owe interest.
This is also a way to earn credit card rewards without paying interest.
Pay off your balance early
Because your credit card company calculates interest daily, there’s a benefit to paying off your balance before your monthly payment due date.
If you carry a balance from month to month, you no longer get the added benefit of the interest grace period, so your daily interest starts accruing immediately. The sooner you pay off that balance, the fewer days the credit card company can add interest based on that balance.
So, paying off your balance as early in your billing cycle as possible will save money on the total amount of interest you pay.
Take advantage of promotional APR offers
Some credit card companies will drum up credit card usage by offering low-interest-rate promotions, such as 1.9% APR for 12 months or 0% APR for 18 months. Some offer these APRs on new purchases only, whereas others offer them on balance transfers only.
The latter is beneficial because you can take the balance from an existing higher-interest-rate credit card, transfer it to the lower interest rate, and save tons of cash. These balance transfer offers often come with a 3% to 5% balance transfer fee. A transfer can be beneficial compared to leaving a balance on a high-interest-rate credit card, even with the fee.
The 0% APR offer also streamlines the repayment plan because you no longer have to worry about the variable interest costs each month that complicate your calculations.
Understanding how interest works helps with financial stability
Understanding how interest works is not only informative, but it can also help set you up for financial success. Knowing how credit card companies calculate and apply interest can guide your credit card use, as you can still maximize reward points without incurring interest charges.
If you're struggling with credit card debt, the Tally† credit card debt repayment app can help. The app helps manage your credit card payments and offers a lower-interest personal line of credit, allowing you to pay off higher-interest credit cards efficiently.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.