Indeed, that credit card comes in handy when you’re doing your Christmas shopping for the whole family or getting those concert tickets.
And by the time you understand what’s going on, interest has already begun to pile up faster than Chipotle toppings. So, how does interest on credit cards work?
What Exactly Is Credit Card Interest?
Credit card interest is a cost the credit card provider charges for borrowing money.
Because here’s how it works:
From eyeglasses to an iPad, you are purchasing it with the credit card company’s money.
But they’re not doing it out of the goodness of their hearts. No, you are required to repay that money on time and in full.
And what if you don’t?
That’s when the company adds interest.
What Is the Process of Credit Card Interest?
Credit card interest is APR (the annual percentage rate).
Despite the name, the annual percentage rate (APR) is monthly or daily.
If you do not pay off your credit card debt before the end of your billing cycle, you will be charged a percentage of the unpaid balance—on top of what you already owe.
Most credit cards have a minimum payment as well.
But, don’t confuse this with paying your entire balance.
While making the minimum payment keeps you current, will still be charged interest on the amount you did not pay.
That’s a lovely notion to pay off your debt each month, but if everyone did it, credit card corporations wouldn’t have enormous skyscrapers and celebrity spokespeople.
In reality, in 2021, only about half (52%) of Americans with credit cards paid out their balance each month.
Don’t even get us started on the various credit card fees that are still available (including annual fees for the “luxury” of holding a credit card).
No, thank you!
What is the average interest rate on a credit card?
It is 20.4% as of 2022 Q4, which is the highest it has ever been! Of course, credit card interest rates are handled differently by different lenders. Also, depending on the type of credit card you have, your interest rate may be greater or lower. Yet, credit card APRs might exceed 20%.
That can quickly add up to… well, a lot of money.
The average credit card debt is actually $5,474.
How Does Credit Card Interest Work?
So, where does your interest payment come from exactly? It’s time to get out your old math textbook, sharpen your pencils, and pull out your graphing calculator. I’m kidding!
1. Determine your APR.
If you don’t know what your credit card’s APR is, now is the time to find out. Your rate will be determined by the type of card you have, so visit the credit card company’s website or call them to find out what yours is. But, if you have many credit cards, you may have more than one APR. Let’s use a credit card with a 15% APR for this example. In decimal terms, this is 0.15. So far, so good.
2. Translate your annual percentage rate to a daily interest rate.
Divide the result by 365, which is the number of days in a year (unless it’s a leap year, but we’re getting off topic). Why? Even though you receive a monthly bill, most credit card firms calculate interest on a daily basis.
So, 0.15 divided by 365 equals 0.00041096. It is the daily interest rate, although it is not nearly the figure we seek.
3. Determine your daily average balance.
Every month, you most likely charge a number of transactions to your credit card. Yet, regardless of your monthly total, the credit card issuer is more interested in the average daily balance you carried throughout the month. To get your average daily balance, go through your recent card transactions and conduct some extra math.
(If you’re curious about your current account balance, check your most recent credit card statement.) Yet, for the purpose of simplicity, let’s pretend your lone credit purchase this month was a new living room set for $2,100.
4. Determine how much you pay each day.
Multiply the daily interest rate you calculated in step two by your average daily balance. This will offer you the amount of interest (in dollars) that is added to your account on a daily basis. In this case, $2,100 multiplied by 0.00041096 represents around 86 cents in daily interest if you miss your payment date. But wait, there’s one more thing!
5. Do not overlook daily compound interest.
In this case, 86 cents every day for 30 days (a typical billing cycle) equals $25.80 in interest. It may quickly build up, especially if you have other purchases on your card. But don’t be surprised if the figure on your credit card bill is larger. Most credit card firms utilize compound interest to calculate daily charges, which is simply interest on interest.
Also, we enjoy compound interest when it helps your money grow. It’s a different story when it’s used against you. Attempting to calculate daily compound interest on your own might be difficult (lucky for credit card companies).
But for this example, we’ll save you the trouble. Just be aware that there is a lot going on behind the scenes to force you to pay more. Not to mention credit card fees and late payments. Furthermore, if you stop making the minimal monthly payment, your loan will become delinquent and go into collections (cue Jaws theme song).
How Is APR Calculated?
Now that we understand how interest is calculated, who determines your annual percentage rate? Credit card firms may appear to simply spin a gigantic APR wheel, but there is some rationale behind the figure. If a credit card company lends you money, they want to know you’ll pay it back.
And if there’s a risk you won’t pay off your credit card account on time each month, they’ll undoubtedly issue you a credit card with a higher APR.
As a result, your interest rate is normally determined by your credit score and income—factors that indicate you’re more likely to pay off your bill on time.
This is referred to as someone’s “creditworthiness” in the credit card industry.
But wait a second. Is borrowing money the only method to prove you’re “worthy” of borrowing money? Who came up with that?
The credit card corporations, of course.
Aside from your own credit history, there are specific APRs for various types of purchases, rewards, and credit accounts.
Here’s a summary of each APR type:
Variable interest rate
Your interest rate may change if you have a variable APR. The rate is usually based on the prime rate, which is an average of the interest rates charged by banks across the country. When the prime rate changes, so does your credit card’s specific interest rate. It implies you could face a sky-high interest rate very quickly. That’s not cool.
Fixed interest rate
Fixed APRs tend to remain constant. But, there are several circumstances in which a company may raise your interest rate. such as if you are 60 days late on a payment. But don’t be fooled by set rates. They can still put you in debt quickly.
APR on Purchase
When you do not pay off your entire credit card amount by the due date each month, you will be charged interest. It is the most fundamental sort of APR.
APR on Cash Advances
When you borrow against your credit limit, many credit cards may charge you a different cash advance APR.
There is no grace period with cash advance APRs ), so you will pay interest regardless of how quickly you pay it back. Furthermore, cash advances often have a higher interest rate than regular purchases. You may also be charged additional costs each time you take out a cash advance.
APR on Balance Transfers
Many credit card firms also have a distinct APR for balance transfers from one card to another (aka a balance transfer). They may provide a reduced rate at first, but they normally don’t last long and will soar back up as the introductory time ends.
Moving your balance from one card to another to avoid paying interest, on the other hand, does not fix the problem; it merely postpones it. Also, there is normally an extra balance transfer fee to pay.
APR Penalty
When you exceed your credit limit or have are late with your payment, you will be charged a penalty APR. Again, you’ll almost certainly be charged late fees on top of that. Ouch.
APR Introductory
As an incentive for opening a specific type of credit card account, credit card firms will provide a reduced introductory APR. However, these low introductory APRs (also known as promotional APRs) normally increase after a specified length of time. You’re already addicted by then. The classic bait and switch.
Additional APR Varieties
There are also retail credit cards, cash back cards, airline miles cards, and cards that grant hotel points—basically, if there’s a benefit, there’s a credit card for it. Yet, credit cards that offer rewards typically have higher interest rates or annual fees. Didn’t you assume the freebies were genuinely free?
Assume you have a credit card that provides 3% cash back. You’d have to spend $1,000 just to earn back $30. Really? That is not a winning strategy. That is being a part of a system that profits from millions of people. Credit card rewards are simply a means of encouraging customers to spend more money each month, increasing the likelihood that they will carry a balance and (you guessed it!) be charged interest.
Don’t get too comfy, even if your APR is reduced. Credit card firms retain the ability to hike interest rates on new cards, and in some situations, rates on current balances—so no APR is guaranteed.
Avoiding the Interest.
Of course, paying your credit card debt in full and on time every month is one approach to avoid paying interest. Nevertheless, as previously said, that only works until your pipes burst during a winter storm or your transmission fails. Credit and emergency do not mix, believe us.
Paying off your credit card and then cutting it up is the easiest strategy to avoid paying credit card interest! Better better, don’t have a credit card in the first place.
But what if you’ve already spent your credit card on a new couch, home entertainment system, or Cabo vacation? A large balance that is threatening to push you into interest area, here are some steps you may do to get out of it.
Make a Budget
When you use a credit card, it can be difficult to keep track of where your money is going and whether you have enough for the rest of the month. Nevertheless, when you create a budget, you will know exactly how much money you have left to spend. You never have to be concerned about exceeding your credit limit or being unable to pay your credit card bill since you have already planned for every single dollar of your salary.
A budget is required if you want to be in charge of your finances. Honestly, this is a game changer. And it doesn’t have to be difficult! EveryDollar allows you to establish a budget for free right now.
Use the Debt Snowball
If you want to avoid paying credit card interest (or more interest than you already have), you must be serious about paying off your amount. And the debt snowball method is the quickest way to get your credit card payments under control because it accelerates your progress and changes your behavior.
Here is how it works:
Step 1: List your debts in descending order, regardless of interest rate (we know we’ve been preaching the importance of interest all along, but trust us when we say it doesn’t matter in this stage). Make minimum payments on all but the smallest balance.
Step 2: Do everything you have to attack the lowest debt. Once that debt is paid off, apply that payment (along with any extra money you can find in your budget) to the next-smallest loan, hile continuing to make minimum payments on the remainder.
Step 3: Once that loan is paid off, apply the payment to the next-smallest debt. As you pay off your debt, your freed-up funds rise and are pushed onto the next loan, like a snowball moving downhill.
The faster you work on your debt snowball, the sooner those credit card payments—and the interest they accrue—will no longer be a burden on your monthly budget.
Employ Alternative Payment Methods
Debit cards, PayPal, Apple Pay, and Venmo are all excellent alternatives to credit cards. Yet nothing beats the satisfaction of paying for something with cold, hard cash. When you swear off credit cards, you can make your purchase without fear of it haunting you later in the form of interest.
Even if you believe you can keep up with your credit card payments, why take the risk? Using credit cards and hoping you won’t have to pay interest is like to dancing across a bed of snakes to collect a McDonald’s Happy Meal toy—you’ll almost certainly get bitten (and it won’t be worth it).
If you want to avoid credit card interest and say goodbye to credit card debt for good, it’s time to break the bad money habits that are holding you back.
It’s time to stop playing the credit card game and start living the life you want with your money.