Comprehending Credit Card Interest

Credit card companies generate revenue in two primary ways. First, they charge fees to retailers, restaurants, and other businesses when you use your card for purchases. Second, they collect interest and fees from cardholders. Here's how credit card interest works and how you can minimize it.

What Is Credit Card Interest?
Interest is the cost that credit card companies impose for borrowing money. It is typically expressed as an annual percentage rate (APR). The APR can either be fixed (remaining unchanged) or variable, with some cards offering promotional APRs that are lower for a limited time.

Many credit cards come with variable APRs that fluctuate based on a benchmark like the prime rate. For example, if the prime rate is 4% and your card charges the prime rate plus 12%, your APR would be 16%. As of September 2024, the average APR for credit cards tracked by Investopedia was 24.74%.

Most credit cards only charge interest if you don't pay off your balance in full each month. In that case, the credit card issuer charges interest on the outstanding amount, adding it to your balance. If you carry a balance over to the next month, you’ll pay interest on the accumulated interest as well. This compounding effect can quickly cause credit card debt to grow.

There’s a brief period during which you won't incur interest—called the grace period. This is the time between the statement date and the payment due date.

Additionally, some credit cards apply different interest rates depending on the type of transaction. For example, the rate for purchases may differ from the rate charged on cash advances or balance transfers.

How Credit Card Interest Is Calculated
If you carry a balance on your credit card, the issuer calculates interest by multiplying your balance each day by a daily interest rate. The daily rate is your APR divided by 365.

For instance, with a 16% APR, your daily rate would be 0.044%. If you had a balance of $500 on the first day, you’d incur $0.22 in interest, bringing your balance to $500.22 by the second day. This process continues daily until the end of the month. By the end of the month, if you didn't add new charges, you would owe $506.60, including interest.

What Is a Good Interest Rate for a Credit Card?
Credit card interest rates vary significantly, so it's important to shop around for the best deal. Generally, individuals with higher credit scores are eligible for better rates, as they are considered less risky by credit card companies.

Knowing your credit score and the range it falls into (e.g., excellent, good, fair, or poor) can help you determine which cards and interest rates you qualify for. You can obtain your credit score for free from several websites, including some credit card companies. However, your credit report, which you can also access for free at AnnualCreditReport.com, doesn't include your score.

Why Pay Your Balance in Full?
Paying off your credit card balance in full is like earning a guaranteed return on an investment. If your card charges 20% interest per year and you pay off the balance, you’re essentially saving 20% by avoiding interest charges, which can be a higher return than many investment options.

If you have extra funds, it’s almost always better to use them to pay off your credit card debt rather than invest them. Paying off your balance frees up more money in the future, as you won’t be paying interest.

If possible, consider transferring your balance to a credit card with a lower interest rate. Many balance transfer cards offer promotional periods of 6 to 18 months with 0% interest, allowing you to pay down your balance faster. Be cautious of balance transfer fees, which usually range from 3% to 5%.

How Much Is Interest on a Credit Card?
Credit card interest varies by issuer, card, and individual, but as of September 2024, the average APR across credit cards was 24.74%.

How Do You Avoid Paying Interest on a Credit Card?
The only way to avoid credit card interest is to pay your balance in full each month. If you do so, no amount is carried over to the next month, so the issuer can't charge you interest. Interest is only charged on the amount that remains from one billing cycle to the next.

Do You Get Charged Interest if You Pay the Minimum?
Yes, you will still be charged interest if you only make the minimum payment. While you won’t incur additional fees, the remaining balance will continue to accrue interest.

For example, if your $500 bill requires a $30 minimum payment, you’ll owe $470 after making that payment. If the interest rate on your card is 20%, that would add $94 in interest, increasing your balance to $564 by the next billing cycle.

The Bottom Line
Credit card interest can quickly become a financial burden, as high interest rates on unpaid balances lead to significant debt. Carrying a balance from month to month can cause debt to snowball, contributing to the U.S. household debt crisis.

To manage your finances effectively, it’s essential to pay off your credit card bill in full each month to avoid high interest charges. If you're unable to do so, create a budget and stick to it to avoid accumulating debt.

 

 

 

 

 

 

 

 

 

Paraphrasing text from "Investopedia" all rights reserved by the original author.