Contributing Writer at Tally
November 20, 2020
About 60% of American credit card holders are convenience users, meaning they avoid interest charges by paying balances in full every month. However, the remaining 40% of Americans are paying interest — and credit card interest is typically high.
But how is interest charged on a credit card? Not fully understanding how credit card interest rates work could lead you into debt quickly. In this article, we answer questions about how credit card interest works so you can learn how to stay debt-free.
Simply put, interest is the cost of borrowing money. Credit card companies charge interest if you do not pay your balance in full every month.
For example, if you charge $500 on your credit card and pay it all off by your statement due date, you won’t have any interest fees. But if you don’t pay the full amount, your credit card issuer will start charging interest on the balance.
Credit card interest rates are known specifically as annual percentage rates (APR). APRs are expressed as a yearly rate. However, your card's interest rate is applied based on your average daily balance.
Although your APR is a yearly rate, your credit card issuer applies it on a daily basis. For example, say your APR is18%. Divide this by 365, the number of days in a year. This yields this daily periodic rate. In this case, it’s .00049.
Next, you need to figure out the average daily balance. The average daily balance is the amount on each day of your last credit card statement divided by the number of days in your billing cycle (typically 30).
Let's say you originally carried a credit card balance of $1,800. Fifteen days into the month, you pay $200 and do not make any new purchases. As such, your new current balance is $1,600. The average daily rate for the month is $1,700 based on the following:
($1,800 x 15 + $1,600 x 15) ÷ 30 = $1,700
Next, multiply the daily periodic rate by the average daily rate:
$1,700 x .00049 = $0.83
Lastly, multiply that figure by the number of days in your billing period to find out how much interest is charged for that period:
$0.83 x 30 = $24.90.
This interest is applied to your outstanding balance. Assuming you did not make any other purchases on the card, your new balance would be $1,624.90:
$1,600 + $24.90 = $1,624.90
The following month, your credit card issuer runs the calculation again to determine your interest charge.
Because interest charges are applied directly to your balance and counted as a part of your balance the following month, you are charged interest on top of interest.
This type of calculation is noticeably different from a mortgage payment, where you pay a fixed amount per month until you pay off the loan. Spending a lot on credit, having a higher interest rate, and not paying your full balance are all things that can lead to accumulating interest on top of interest.
There are different types of APRs, complicating credit card interest even further. Your purchase APR is the standard rate charged by your credit card company. Other kinds of APR include:
Promotional APR: This is a lower interest rate applied during a specified period of time, such as the holidays or the first 12 months after opening a new credit card. You may also see this referred to as the introductory APR.
Cash advance APR: This higher interest rate is applied if you withdraw cash at an ATM using your credit card. You may also be charged a cash advance fee.
Penalty APR: This higher interest rate is applied if you make late payments.
Credit card issuers require you to make minimum payments on your credit card bill each month. If you’re late or miss a payment, you’ll incur a penalty APR and late fees.
Balance transfer APR: This is specific to balance transfer credit cards. These are useful for paying down credit card debt if you have multiple cards. Typically, balance transfer cards offer a low interest rate (as low as 0%) for the first year. There is also a balance transfer fee of 3% to 5% of the total amount transferred.
It's also worth noting that most credit card interest rates are variable. This means that the issuer can change your rate, either higher or lower. Typically, rates fall within a specific range. You may see language in your credit card terms and conditions such as "a variable purchase APR between 23.99% and 27.99%."
Although credit card companies can change the rate, they cannot do so without advanced notice. Companies must give you at least a 45-day advance notice of a rate increase.
If you pay your outstanding balance in full each month, you don't need to worry as much about your APR. It's essential to understand the difference between paying your balance in full and making the minimum monthly payments.
For example, suppose your billing cycle ends on January 31. Between January 1 and January 31, you charge $500 on your credit card. Your statement at the end of the month will reflect your $500 balance. At this point, you do not have any interest charges.
Your credit card issuer must give you a grace period to pay your balance. This grace period must be at least 21 days. When looking at your credit card statement, you’ll see something like, "Minimum payment of $25 due by February 21."
You have four options, each of which will have a different impact on your credit score:
Miss the payment. This will trigger late fees and penalty APRs and do the most damage to your credit report. Doing this consistently will lead to bad credit.
Pay the minimum $25, leaving a balance of $475. Not making the full payment and carrying the $475 balance to the next month can negatively affect your credit score, depending on your credit utilization (more on this later).
Pay more than the minimum $25, but not the entire balance. This will do minimal damage to your credit score, but will still have an impact since you’re carrying debt.
Pay your unpaid balance of $500 in full. This will improve your score and is one of the best paths toward good credit.
For the sake of example, say you choose option 2. Because you make the minimum payment, you are not charged late fees or penalty APRs. The outstanding balance of $475 rolls over into the next month and is used for the average daily rate calculations. You’ll be charged interest on the following month's statement since you did not pay your balance in full.
Having a good credit score opens financial doors. By contrast, having a poor credit score can limit your options significantly.
For instance, a good credit score gets you access to the best interest rates. The higher your credit score, the likelier you can secure lower interest rates. Having a good credit score may also include benefits such as waived annual fees or other credit card fees, extensions on a payment due date, or longer promotional offers.
Paying your balance in full is the best way to ensure a good score. Doing this with multiple credit cards is even better. It demonstrates to lenders that you’re responsible with your money and will likely pay on time.
Paying in full also prevents credit card interest from racking up and can help keep you out of debt. Keeping your monthly balance low will reduce your credit utilization, which is the amount of credit you use compared to the total amount you have available.
If you currently carry credit card debt and want to improve your credit score, consider using a balance transfer card or a credit card payoff app like Tally. Both of these debt management tools require one payment each month, so you no longer have to worry about tracking multiple credit card due dates.
For instance, Tally will then take your payment and pay off your cards using the debt avalanche method. Doing so pays off high-interest credit cards first, allowing you to get out of debt more quickly. The sooner you’re debt-free, the sooner you can start saving money for other financial goals.
Balance transfer cards and Tally are for those with a good credit score. However, there are some balance transfer cards for fair credit. If you don’t have good credit, consider the debt avalanche or debt snowball method to build your score and chip away at your debt.
Before you start spending money on credit, you must first be able to answer the question, "How is interest charged on a credit card?"
Credit card interest is unique because it’s compounding, meaning you’re charged interest on both your purchases and the interest you've accumulated from purchases made in previous months. If you’re not diligent about paying your monthly balances, your credit card debt can snowball fast.
If you have good credit but have a bit of debt, consider using tools like Tally or balance transfer cards to help. If you’re in debt but have poor credit, research the debt avalanche and debt snowball methods to learn more about how you can begin your journey to becoming debt-free.