How Does Credit Card Interest Actually Work?

How Does Credit Card Interest Actually Work?

June 4, 2014         Written By Lynn Oldshue

Why You Should Know How Credit Card Interest Works

Credit cards are a great tool for individuals who don’t always have the necessary cash on hand to make a purchase. Most people don’t have unlimited access to capital, and that makes credit cards one of the only ways to get instant lines of credit that don’t come with a number of strings attached. But that doesn’t mean the money you get from credit cards is free. If you don’t know how credit cards work, or if you are unsure about how the interest is calculated, you can end up paying much more than you planned. That’s why it is important to get a handle on your credit card spending and know the terms of agreement with your credit card company. A significant percentage of credit card consumers don’t take advantage of the tools available to them, and they don’t understand the fine print of their contracts. Don’t let that be you. If you know how credit cards work, you’ll save yourself some money in the long run.

How To Calculate Credit Card Interest

Most people don’t fully understand how credit cards companies calculate interest. It almost seems that credit card companies make their agreements difficult to understand especially in regards to the interest calculations. If you are not fully aware of how credit card interest is determined, you may be more likely to spend beyond your means and run up a large interest penalty. You can avoid those problems by paying your card off in full on time each month. But a substantial number of people don’t do this, because they need the line of credit in order to make larger purchases in the first place.

Most interest from credit card companies is compounded each day. Compound interest means that the interest charges that you accrue are added to the principal, or the amount that you borrowed in the first place. Most issuers compound interest daily–they take your annual interest rate and divide it by 365. That daily interest figure is multiplied by your loan balance to get your daily interest charge. The result is added to your daily credit card balance.

Most people assume that this compound interest is working monthly, but that’s not true for the vast majority of credit card companies. With large amounts of money, this exponential system can quickly spiral out of control.

Let’s say you have a balance of $1,000 on your credit card and you are charged an annual interest rate of 15%. If you divide that 15% by 365 days, your daily interest is 0.041%. So after carrying that $1,000 balance for one day, you have incurred interest charges of 41 cents. On day two, you’ll be charged that 0.041% interest on $1,000.41. That might seem small, but with large amounts of money, daily compounding interest can become a serious problem for borrowers. That is why it is important to keep your average balance on your credit card as low as possible.

When You Get Charged Interest

The answer to the question of when you will get charged interest can be a complex one. A number of credit cards come with an introductory offer that gives the consumer 0% interest for a period of time. This may range from six to eighteen months. Those with better credit histories will get access to the longer introductory periods. But nobody gets lines of credit at 0% interest forever, and after that, you’ll have to start paying interest on any balance you carry from one month to the next. The vast majority of credit cards will allow you to pay off your balance at the end of every month with no interest—but once you don’t pay off your card in full, you start running into interest payments which must be made on the remaining balance.

What Impacts Your Credit Card Interest Rate

While you know that your credit card’s interest rate, or APR, affects how much you will pay each year in interest, you might not know how companies get to that number. Credit card companies will give you an APR based on a myriad of factors, including the prime rate, your credit score, credit card promotions and your credit payment history.

The prime rate is based on economic variables that are tied to the interest rates that banks pay for short term borrowing from the Federal Reserve. As a rule, the prime rate is three points higher than the federal rate. If the Federal Reserve charges banks more to borrow, which increases the prime rate, then your credit card’s APR will also increase, likely by the same amount.

Your credit score obviously affects how much money you can borrow and your interest rate. Those with high credit scores get lower interest rates, and the inverse is true is well.

Credit card companies offer promotions on their cards as a way to secure more customers. Many of these promotions are introductory offers that allow credit card consumers to pay low or no interest for a period of time. Many of these offers shift to high APRs once the introductory period ends, which can cost consumers more money in interest.

Your credit payment history also affects your interest rate. If you make a late payment, it could directly affect your interest rate.

As a consumer, you need to stay abreast on how credit cards work and how your relationship with a credit card company will affect your finances. Make sure that you know all the details before you sign up.

The information contained within this article was accurate as of June 4, 2014. For up-to-date information on any of the terms, cards or offers mentioned above, visit the issuer's website. Many of the offers on this article are from our affiliate partners, and may be compensated if you take action with any of our affiliate partners.


About Lynn Oldshue

Lynn Oldshue has written personal finance stories for for twelve years. She majored in public relations at Mississippi State University.
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