How Do Credit Card Interest Rates Work?
6 minutes read
Many people wonder how credit card interest rates work and what determines their interest charges. Several factors ascertain interest rates, and their exact makeup is a bit complex. Credit cards use annual percentage rates (APR) in conjunction with interest rates. While they are technically distinct, the two are vitally connected. Interest rate is calculated by dividing APR by 365 for the number of days in the year. This will tell you the daily interest rate on your credit card balance if it carries over more than one month. So, if your card’s APR is 15 percent, your interest on any outstanding balance will be 0.41 percent each day.
Outstanding balances are unpaid purchases and interest from previous periods. Credit card interest applies to your principal balance from purchases, but it also applies to any interest you accrue. Your interest also applies to the average daily balance throughout each billing period. This means that if you have a balance at the start of a new billing period and make more purchases, the total amount charged will be more than the original balance.
Why Interest Rates Are Not Always Applied
In some cases, card issuers do not apply interest charges. For example, if you have no balance from one billing period to the next, you will not be charged any interest. Many card issuers even offer a grace period of up to a month without charging interest, starting from the date your bill became available to the day payment is due. But you can lose this grace period if you have an outstanding balance on your payment due date. This is known as a revolving balance, but you can avoid the interest charges if you pay the balance in full on your previous two bills by their due dates.
If you do receive an interest charge after paying your balance to zero, this could be a mistake on your card issuer’s part. However, most of the time, these charges happen because cardholders misunderstand part of how credit card interest rates work. If you start a new billing cycle with a revolving balance, you accrue interest each day. If you pay your original balance, this will no longer be enough to bring it to zero. Instead, you will still need to pay the interest that accrued from the day your bill became available and the day you paid it.
How Issuers Determine Interest Rates
Interest rates are the product of your card issuer’s examination of your disposable income and credit score. Cardholders with excellent credit ratings tend to have much lower interest rates than those with recovering credit. This means that those with good credit immediately benefit the most from using credit cards. However, credit cards can still help those building their credit if used responsibly. Credit cards can also help maintain a solid credit score.
Your credit score determines which tier of offers you are qualified to receive. It will also change the rate you get if you are offered a variety of potential APRs. Regardless, credit card companies can change interest rates for existing accounts under specific circumstances. Interest rates can be raised on new transactions at any time as long as cardholders receive 45 days’ notice of the change. Card issuers can also increase the rates on existing business balances. For general consumer cards, issuers can also raise rates if you are 60 days delinquent in payment. On the other hand, interest rates could decrease at any moment. This usually happens because cardholders improve their credit scores or agree to a debt management arrangement.
Most interest rates are connected to an economic index like the Prime Rate. This rate changing can cause interest rates to fall or rise in general, which then affects your card’s interest rate.
How to Reduce or Eliminate Interest Charges
The best way to eliminate interest charges is to repay what you charge on your card each month. However, this is not the only way to remove, or at least significantly reduce, interest charges. There are a few simple strategies that help ensure your account does not get additional fees. These include:
- Pay down the balance ASAP. Interest accrues every day. If you wait for your due date, you will be charged for the days between the due date and your bill becomes available. To eliminate these charges, repay your balance the day your issuer makes it available.
- Use a zero percent card. These let you avoid interest charges for a few months after you open the account. Make sure you make your minimum monthly payments, as this keeps your APR at zero percent. Additionally, make sure you repay most or all of your balance before the card’s higher APR kicks in. Interest charges usually apply to unpaid balances after the introductory APR expires. Zero-percent cards often include deferred interest. Deferred interest charges occur when you do not repay the entire balance by the end of the initial term. The interest rate then applies retroactively to your original purchase amount. It is in your best interest to altogether avoid deferred interest payment plans if possible.
- Use a credit card calculator. You need to approach credit cards with concrete plans to repay your balances on time. Credit card calculators can help you calculate how much you should pay monthly. Some of them have additional features, like showing cards with best interest rates and fees.
- Separate ongoing purchases from revolving debt. This ensures interest rates are applied to the lowest amount possible. Everyday expenses are a perfect fit to isolate on a separate card since they can usually be paid in full each month. By isolating costs to one card, it keeps the daily balance from rising for no reason. This lowers interest charges overall.
- Request a lower limit. If your credit card limit allows you to spend more than you can quickly repay, you should request a lower credit limit. This will remove the temptation and help you get your finances back on track.
The Bottom Line on Credit Card Interest Rates
Now that you know how credit card issuers calculate your interest rates, you have a bit more insight into their potential effects on your finances. You can see which factors you can change to lower your rates and which factors are out of your control. However, even without this more in-depth understanding of how interest rates work, you can know that debt can be very damaging to your financial health. Interest charges can quickly become quite expensive and even unmanageable. Eventually, you could miss payments and damage your credit rating. You can help yourself avoid these problems by reviewing your spending habits regularly, avoiding any unnecessary debt, and keeping a budget as much as possible.