Understanding Interest Rates on Credit Cards

The more you know, the less you may have to pay in the long run.

There are two ways in which credit card companies make money. A prime example is the fees that credit card companies charge to merchants such as retailers, restaurants, and other sellers of goods and services when you use your card to make a purchase. The other is the interest and fees that are charged to you by the lender. Here’s how credit card interest works, as well as some tips for paying less of it.

The Most Important Takeaways

  • Companies that offer credit cards will charge you interest if you do not pay off your balance in full each month.
  • A variable interest rate is charged on most credit cards, which means that it will fluctuate from time to time.
  • There are several interest rates on some credit cards, such as one for purchases and a second for cash advances.
  • Your credit score can have an impact on the interest rate you’ll pay as well as the types of credit cards you’ll be eligible to use.

What Is the Definition of Credit Card Interest?

To borrow money, credit card companies charge you interest, which is a fee for the privilege of borrowing money. It is commonly expressed as an annual percentage rate, abbreviated as APR for short.

Most credit cards have variable annual percentage rates (APRs) that fluctuate in response to a specific benchmark, such as the prime rate. To illustrate, suppose the prime rate is 4 percent and your credit card charges the prime rate plus 12 percent, your annual percentage rate (APR) will be 16 percent. The average annual percentage rate (APR) of credit cards tracked in database was 19.62 percent as recently as last month.

With most credit cards, you will only be charged interest if you do not pay your bill in full at the end of every month. As a result, the credit card company accrues interest on your unpaid balance and applies it to your total credit card account balance. Consequently, if you do not pay off your balance in full the following month, you will be charged interest on top of interest charged. This is how credit card balances can balloon quickly and sometimes become uncontrollably high.

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Additionally, some credit cards charge multiple interest rates, which makes things even more complicated. Examples include charging one interest rate on purchases while charging another (usually higher) rate on cash advances.

Understanding Interest Rates on Credit Cards

What Is the Process of Credit Card Interest?

A balance on your credit card will be multiplied by a daily interest rate and added to the amount owed by the credit card company if you carry a balance on your card. The daily rate is calculated by dividing your annual interest rate (the APR) by 365 days.

Suppose your credit card has an annual percentage rate of 16 percent; the daily rate would be 0.044 percent. If you had a $500 outstanding balance on Day One, you would accrue $0.22 in interest on that day, for a total of $500.22 on Day Two, assuming you had a $500 outstanding balance on Day One.

This procedure will be followed until the end of the month. The following example shows what happens when you have a $500 balance at the beginning of the month and no other charges are added: you end up with a balance of $506.60, which includes interest.

When it comes to credit cards, what is a good interest rate to look for?

When it comes to credit card interest rates, there is a wide range, which is one reason to shop around when looking for a new card. A good rule of thumb is that the better your credit, as represented by your credit score, the better the interest rate you will be eligible to receive. Because you have a higher credit score, the credit card company will consider you to be a lower risk than someone who has a lower score.

Having an understanding of your credit score and the range into which it falls (for example, excellent, good, fair, poor) can assist you in determining which credit cards and what kinds of interest rates you might be eligible for before you apply. The ability to obtain your credit score for free is provided by a number of websites, as well as by some credit card companies. It is important to note that your credit reports, which you can also obtain for free from AnnualCreditReport.com, do not contain your credit score information.

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Two Interest Rate Scenarios for Paying Off Credit Card Debt

Consider the following scenario: John and Jane each have a $2,000 balance on their credit cards, which require a minimum monthly payment of 3 percent of the balance, or $10, whichever is greater. Both Jane and her husband are struggling to make ends meet, but Jane manages to pay an additional $10 per month on top of her minimum monthly payment. John only makes the bare minimum payment.

Every month, John and Jane are charged interest on their outstanding balances on their credit cards, with an annual percentage rate (APR) of 20 percent. When John and Jane make payments, a portion of their payment is applied to interest and a portion is applied to principal (their balance).

The following is a breakdown of the numbers for John’s credit card debt during the first month of the month. The interest is shown on a monthly basis, rather than on a daily basis, for the sake of simplicity.

  • 2,000 dollars as a down payment
  • Payment is in the amount of $60. (3 percent of balance)
  • Interest: ($2,000 x 20%)/12 months = $33.33 per $1,000 of principal.
  • $60 less $33.33 equals $26.67 in principal repayment.
  • $2,000 minus $26.67 equals $1,973.33 in remaining balance.

These calculations are carried out on a monthly basis until the credit card debt is completely eliminated.

If John continues to pay only the minimum amount due on his credit card debt, he will spend a total of $4,241 over the course of 15 years to pay off his $2,000 in credit card debt. Simply paying the interest will have cost him $2,241.

The Repayment Schedule for John

Adding an extra $10 a month means Jane will pay a total of $3,276 over seven and a half years to pay off her $2,000 in credit card debt, which is an increase from her previous contribution. It will cost her a total of $1,276 in interest charges.

Jane’s Schedule for Repayment

Comparing Jane’s savings with John’s, the extra $10 a month saves her nearly $1,000 and shortens her repayment period by more than seven years.

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The lesson to be learned here is that every little bit helps. Paying at least twice the minimum amount each month can significantly reduce the amount of time it takes to pay off the balance, resulting in lower interest charges overall.

Of course, while it’s beneficial to pay more than the bare minimum, it’s preferable not to have any outstanding balance at all.

What are the benefits of paying your balance in full?

Getting a yearly return on your stock portfolio of 17 percent to 20 percent would be fantastic for any investor, wouldn’t it? In fact, if you were able to maintain that level of performance over the long term, you should probably start your own hedge fund.

In many ways, paying off your credit card debt is similar to receiving a guaranteed rate of return on your investment. Because credit cards charge 20% interest per year, paying off your balance is a surefire way to save 20%, which is roughly equivalent to earning 20% on your investment.

It is almost always preferable to use excess cash to pay down credit card debt rather than to put it into investments when you have extra funds available. Paying off your balance and eliminating credit card interest will leave you with more money to put aside for future investments, which will help you build wealth.

If you are eligible, transferring your current credit card balances to a balance transfer credit card with a lower interest rate may be a viable interim strategy to consider. Many of these cards offer promotional periods of six to 18 months during which they charge zero percent interest on your balance, which can help you avoid paying interest on your balance in the future and pay it off faster by delaying the accrual of new charges. Just keep an eye out for balance transfer fees, which can add anywhere from 3 percent to 5 percent to your current account balance.

And, whatever you do, keep in mind that you must continue to pay!

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