When you carry a balance on your credit card, you’ll undoubtedly notice it’s more than you initially charged. That’s because interest is added each month you fail to pay your bill in full. Because this number is constantly changing, it can be difficult to figure out why you were charged a certain amount and what you can expect to pay for future balances.
Here’s everything you need to know about how credit card interest is calculated to give you clarity on what you’re actually paying each month you hold a balance. With this information on hand, you’ll be able to create a credit card strategy that saves you money over the long run.
How Credit Card Interest Works
If you want to really understand how credit card interest works, you have to look at the way it’s charged. Credit card companies generally advertise interest rates as an annual percentage rate or APR. This helps you get an idea of how much you’ll be charged so you can compare your various offers.
In reality, however, you’re actually wracking up interest on a daily basis, so you need to figure out your card’s daily periodic rate. This varies slightly depending on your creditor but in most cases, you simply take your APR and divide it by 365 to represent each day of the year. The next figure used in figuring out your credit card interest is your average daily balance. This takes the average balance of each day of a billing cycle, which is then multiplied by the daily periodic rate. That number is then multiplied by 30 to account for the number of days in your billing cycle.
It may sound complicated, but math equations usually are when spelled out in words rather than numbers. Let’s take a look at a case study to get an idea of what credit card interest looks like in real life.
Case Study: Calculating Interest
As an example, we’ll use the number facing the average American today. The average credit card balance is $5,700 and the average APR is about 17%. Let’s say you carried over the fully $5,700 from your last statement and didn’t make any additional charges that month. You would divide the amount by 30 days to get an average daily balance of $190.
Next, we’ll determine the daily periodic rate by dividing the 17% APR by 365 days: 0.04%. Finally, let’s multiply the average daily balance ($190) by the daily periodic rate (0.004) and 30 (for 30 days in a billing cycle). The total interest charged for that month comes to $22.80. Added to the original $5,700 balance, you’ll now owe $5,722.80. If you did make new charges throughout the month, you’re still charged interest, but only from the point when you made the charge, not the entire statement period.
Types of Credit Card Interest
Another important factor in the amount of interest you’re charged is the type of interest. Depending on the terms and conditions of your card agreement, you may actually have different APRs based on the type of purchase that’s made with the card. Here are five types of credit card interest you need to know about.
The purchase APR is the standard APR you’ll be charged for regular purchases using your credit card. You won’t be charged anything if you pay off your balance in full each month, but if you carry a balance you’ll be charged on both old and new amounts. While you’re quoted a purchase APR when you first sign up for your card, it’s important to know that it’s a variable rate that can change based on the prime rate.
In some cases, you may be offered an introductory APR for a predetermined period when you first sign up for a credit card. Sometimes you can even find a 0% introductory APR, which can last for several months. It’s a great way to finance a major purchase without getting interest charged to your account. If you miss a payment, however, you may end up paying a high rate, so read your terms and conditions carefully to understand how the details work.
Balance Transfer APR
Similar to an introductory APR, a balance transfer APR is the amount of interest you’ll pay on any balances you move from one credit card to the new one. Usually, it’s much lower than the purchase APR as a way to entice you to open a new account. You might be able to find a 0% APR for balance transfers, which can give you a reprieve on accruing new interest while you work to pay off that debt.
On the downside, credit card companies typically charge a balance transfer fee, which can add a percentage of your balance to your total new bill. For example, if you transfer $5,700 and the balance transfer fee is 3%, you’ll add an extra $171 for moving your debt to the new card.
Cash Advance APR
Another type of APR is the interest rate you’re charged for using your credit card to get cash rather than make a purchase. You’re usually charged at a higher rate for this service, so it’s important to utilize your card’s cash advance feature carefully. An additional notable difference is that there’s no grace period for a credit card cash advance. Your APR starts right away, even if you don’t have any other balance on the card. There might also be a processing fee charged, typically ranging between 3% and 5% of the advance amount that is charged on top of the APR.
Many credit cards charge a penalty APR if you’re late on making a payment. That means your regular purchase APR automatically bumps up to a higher rate. This usually kicks in once your account goes unpaid for 60 days or more. You’ll be notified on your statement if you do get hit with a penalty APR, which can be as high as 29.99%. Plus, the higher rate is charged both on your current balance and any new purchases made with the card.
This rate can stay in effect on your entire card balance for up to six months. After that, you’ll go back to your normal rate on your balance but you may keep getting charged the penalty rate for future purchases.
How Your APR is Determined
Your original purchase APR is determined by the information gathered during your credit card application. Creditors use your credit score and history as the primary factors to determine your APR. When you have a positive credit history and a high score, you’ll pay less in interest. On the flip side, you’ll get a higher APR if you have negative credit entries and a lower score.
What information is used to determine your credit score, and ultimately your APR?
There are five categories used by the credit scoring models to give you an idea of what’s helping or hurting that APR on your credit card. Here they are listed in order of importance.
Your credit score is most impacted by how well you’ve made payments on loans and credit cards in the past. Any payments made 30 days late or more are usually reported to the credit bureaus and cause a drop in your score. The more you have, the higher APR you’re likely to receive.
This category reflects how much debt you’re currently carrying, particularly in relation to how much you have available to you. Maxed out credit cards are especially detrimental. It’s generally recommended to keep your balance under 30% of your limit.
Credit History Length
The longer you’ve had credit, the higher your score rises because it shows you’re reliable and have had continued access to credit. This category uses your average credit age, so lots of new accounts at once can lessen the impact of one older account.
You’ll see a jump in your credit score when you have a more diverse mix of credit types. For example, having installment loans in addition to revolving credit shows that you can get approved for multiple types of credit. Plus, installment loans show that you might have equity in property like a car or home.
Every time you apply for a new credit card or loan, it’s listed as an inquiry on your credit report. Some types of credit applications are grouped together if it’s clear you’re rate shopping. Multiple car loan applications over a two-week period, for example, clearly shows you’re looking for the best option, not buying five different cars. It’s different with credit cards, however. Each inquiry counts separately on its own and can drop your score between 5 and 10 points each for a year.
The Bottom Line
By understanding all of the details impacting your credit card APR, you’ll gain a firmer grasp on when you’ll be charged interest and how much you’ll owe. All of this contributes to a better understanding of your finances so you can make strategic decisions every step of the way.