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How Does Credit Card Interest Work?
How does credit card interest work? If you’re going to open a credit card, you should know. Of course there is a lot to be said about the perks of a credit card – reward points, airline miles and introductory specials. But the credit card interest can make those perks a lot harder to understand and resolve.
In perfect world nobody should have a credit card balance. In the real world, however, it’s common to carry a balance on your credit card, which means you are paying a potentially steep price for the convenience of credit. That steep price is paid through your interest, which is why you should always ask the question: how does credit card interest work?
Understanding Interest and APR
When you open a credit card, you are essentially opening a loan with revolving credit. You have a credit line established by the issuing bank and the interest rate they are charging you is the cost of doing business, but only if you carry a balance.
If you use all the credit limit on your card and then make only the minimum payments, you are borrowing very expensive money. You will take some time to pay the borrowed money back, and every month the bank will charge you additional interest for having borrowed it in the first place.
Interest on credit cards is also called the APR, or annual percentage rate. While “annual” is in the name, the interest rate is actually charged on a monthly basis. The higher your balance every month, the more interest you’ll be paying.
Fixed and Variable APR
There is more to it to effectively answer, how does credit card interest work? You have to take into account the type of APR offered on the card. There are two primary types – fixed APR and variable APR. A fixed APR is a number that is set when you open your account and doesn’t fluctuate on a monthly basis. A variable APR is based on the prime rate, which fluctuates based on several banking factors.
A variable rate can change along with the prime rate. A fixed rate should remain steady unless it is an introductory rate or you fail to meet their criteria. For example, a missed payment can raise your monthly rate.
While there are two primary types of APR, you can find these types applied across a range of numbers when you open a new credit card.
- An APR for purchases is the interest rate applied to things you buy with the credit card.
- A balance transfer APR is applied to a balance that is transferred from one credit card to another.
- A cash advance APR is the interest rate charged if you get cash from an ATM using your credit card. This is often the highest APR in the set and does not have any grace period for repaying the amount before interest is charged.
- Introductory APR is a promotional offer that is available for a set amount of time or for a set amount of spending. You might have a promotional introductory APR of 0% interest for the first six months before the more standard purchase APR is applied.
- A penalty APR is the amount you pay when you fail to make payments on time. This amount can be even higher than a cash advance APR.
In some cases your APR will be determined by the card. Everyone might pay the same interest rate, for example. In other cases, your credit score may influence how much interest a company will choose to charge.
Calculating interest using your APR
We are halfway there on understanding how does credit card interest work. It’s one thing to understand the interest rate. It’s another to see it in action.
Calculating your interest rate is done automatically by the credit card, of course, but to see how much debt will really cost you, you should understand how these calculations actually work.
Let’s say you have a credit card with a balance of $1,000. The APR on that card for purchases is 16.99%. At the end of the 30 day billing cycle, you will be charged interest. Here is how the bank will do the calculation.
Step 1: The APR of 16.99 will be divided into the number of days in the year. So 16.99 percent divided by 365, or .0004655. That is how much interest is charged every day.
Step 2: Multiply the daily rate by the balance of $1,000. $1,000 multiplied by .0004655 is $0.47.
Step 3: Multiple your daily balance by the number of days in the billing cycle. This amount is usually 30, but could be more or less. 30 days multiplied by $0.47 per day is $14.10.
You have paid $14.10 that month for borrowing $1000 through your credit card. Carry a $10,000 balance and you’re paying $141 every month for the privilege of borrowing money. So, how does credit card interest work? In some potentially expensive ways if you carry a balance.