Approximately 1 in every 2 Americans are burdened with credit card debt. And according to Experian’s State of Credit report, the average credit card debt is $6,354.
It doesn’t take much to fall behind on credit card payments, but do you know how interest charges are calculated when you are in the red?
If you have ever wondered how does credit card interest work, you might be surprised by what you discover!
In this article, we will show you how you can calculate interest charges on your monthly credit card statements in order to make better financial decisions.
Table of Contents
- How Do Interest Rates On Credit Cards Work?
- How To Calculate Interest On A Credit Card?
- How To Avoid Paying Interest On A Credit Card
- How Do Balance Transfer Credit Cards Work?
- What Other Factors Affect Credit Card Interest Rates?
- How Credit Card Interest Works: The Bottom Line
How Do Interest Rates On
Credit Cards Work?
When you make purchases on your credit card, an APR (Annual Percentage Rate) may be applied to balances that are not paid off in time.
The APR can seem misleading because most consumers focus on a yearly time frame.
For example, a consumer might think that a 20% APR applied to a $10,000 credit card debt balance would cost them $2,000 over a 12 month period.
But it’s not that simple!
Credit card companies convert APR rates to daily percentage rates. So a 20% APR actually converts to a daily percentage rate of 0.05479%.
It may seem odd that they would do this until you dig a little deeper and discover that card issuers will multiply your current credit card balance by the daily percentage rate to arrive at a daily interest charge.
The daily interest charge is then added to your credit card balance the next day.
If you ever wondered why it is so hard to figure out how to pay off credit card debt, a big reason is the power of compounding is working against you.
How To Calculate Interest
On A Credit Card?
The power of compounding means you end up paying a lot more in interest charges than you might expect.
And it takes a lot longer to pay off credit card debt than you may intuitively think.
For example, imagine you had $10,000 of credit card debt at an APR of 20% and decided to pay $500 each month, how long would it take to get out of credit card debt?
|Balance||APR Rate||Monthly Payment||Payoff Timeline|
The total interest charges over the 25 month time period would be $2,266.
So why does it cost more than you think?
The answer lies in how that pesky daily percentage rate works.
With a balance of $10,000 and a daily percentage rate of 0.05479%, the interest charge of $54.79 is added to your principal balance the next day.
The same process continues each day until the end of the monthly billing cycle.
So on day 2, you will be charged 0.05479% on $10,054.79.
You can quickly see how the power of compounding works against you because the daily percentage rate is continually charged on an ever growing principal balance!
Left unchecked, compound interest can cause credit card debt to spiral out of control. In fact, Einstein is said have stated:
|“The power of compound interest|
is the most powerful force in the Universe”
How To Avoid Paying Interest
On A Credit Card
Generally, your credit card company will not charge you interest on purchases when you pay your balance in full by the billing due date.
The period when no interest is applied is called a grace period, and it typically lasts for 21 days.
But keep in mind that the grace period can be forfeited by not paying your bill on time.
If you are struggling to keep up with your credit card payments, you may wish to consider some form of credit card debt relief.
Balance transfer cards are among the most popular ways to defer interest charges.
However, you will typically stop earning rewards points, cash, and miles bonuses when you move your balance to a lower interest rate balance transfer card.
So how do balance transfer cards work?
How Do Balance Transfer
Credit Cards Work?
When you choose a balance transfer credit card, your balance switches from your current card to a lower interest rate card.
Many of the best balance transfer cards, such as the Discover It – 18 Month Balance Transfer card, offer 0% interest introductory offers.
Once you make the switch, your interest rate charges are placed on hold.
However, a fee in the range of 3% → 5% will be applied when you make the switch.
So, on a $10,000 balance the fee could range between $300 → $500.
And while that is a hefty price to pay, it can work out to be quite a bit cheaper than paying high interest charges over a long time period.
|Tip: Pay attention to the timeline when the teaser offer expires because the new interest rate may be higher.|
Like many of the best balance transfer credit cards, Discover and Chase offer generous time periods when interest rates are low.
Lastly, you will need a good credit score to qualify for a balance transfer. If you are not sure how good your credit is, MyFICO can help you out.
What Other Factors Affect
Credit Card Interest Rates?
Always review your cardmember agreement terms for specifics about which factors affect your credit card interest rates.
Penalty Interest Rate
A common cause for higher interest charges is failure to pay on time.
This usually triggers a penalty interest rate that can be avoided by setting up automatic bill payments.
Generally, the penalty interest rate applies when you are more than 60 days late. It is typically the highest APR rate that the credit card issuer can apply.
Credit card issuers usually reward customers with excellent credit scores (750 or higher) by providing lower APR rates because they are considered lower risk.
If your credit score is fair (between 550 and 699), you may be categorized as having higher risk and be charged a higher rate as a result.
Fed Rate Hikes
Even if you don’t do anything wrong, your interest rate can increase.
When a Fed rate hike takes place, variable interest rate charges generally increase too.
Credit card issuers alter variable interest rate charges based on the Prime Rate, which is 3% higher than the Federal Funds Rate controlled by the Federal Reserve.
How Credit Card Interest Works:
The Bottom Line
The best way to avoid high credit card interest is to pay off your balance in full each month. But when you fall behind on credit card payments, you may be charged higher interest rates.
Interest charges compound over time, so where possible set up an automatic bill payment plan.
If you are late in paying your bill, a penalty interest rate usually kicks in after 60 days. This is often the highest APR rate applied by the credit card issuer.
You can defer high interest rate charges by moving your balance to a 0% balance transfer card, especially if you have a good credit score.
If your credit score is fair to poor, strive to make full payments consecutively. Generally, if you can make a handful or more in a row, you may be rewarded with a lower rate.
Are you clear about how credit card interest is calculated? Share your tips about the best way to pay off credit card debt.