How does credit card interest work? #CashNews.co

What would you do with an extra $1,000 per year? That’s the average amount Americans pay in credit card interest and fees per year, according to the Consumer Financial Protection Bureau (CFPB) .

But how does credit card interest work? It’s one of the most common questions new credit card users ask. Understanding when credit card issuers charge interest and how it’s calculated is fundamental to managing your finances. Knowing how to reduce interest charges — or eliminate those charges entirely — can help you save a substantial amount of money

How does credit card interest work? 5 things to know

Credit cards are popular tools; they allow you to quickly and easily make purchases online or in person, and they eliminate the need to stop at the ATM to withdraw cash.

However, credit cards can be expensive. According to the Federal Reserve, the average interest rate for cards was 22.77% as of August 2023, the last available data. That rate is significantly higher than the rates for other forms of credit, such as personal loans or car loans.

Understanding these five key details about credit cards can help you manage your debt more effectively:

1. Your rate is part of the Annual Percentage Rate (APR)

With credit cards, you’ll see their rates listed as APR. The APR is a percentage that represents how much the credit card issuer will charge you in both interest and fees over a one-year period.

APRs vary based on the card and your credit history. In general, you can qualify for cards with lower APRs if you have very good to excellent credit.

2. Credit cards can have different APRs

You may be surprised to learn that credit cards have more than one APR. Different rates apply to certain types of transactions. With a credit card, you’ll typically have the following APRs:

• Purchase APR: The purchase APR is the rate you’ll pay when you use your card to pay for purchases or services.

• Balance transfer APR: The balance transfer APR applies to balances you transfer from one credit card to another.

• Cash advance APR: The cash advance APR only applies to cash withdrawals you make with your card. The cash advance APR is usually higher than the purchase APR.

• Penalty APR: If you miss a payment or are late, the credit card issuer may charge you a penalty APR — a higher rate that will apply to all transactions going forward.

3. You may have a grace period

Most credit cards give users a grace period — a period of time between the end of the billing cycle and the date your minimum payment is due. During the grace period — which is typically about 21 days — the credit card company doesn’t charge you any interest. But if you don’t pay off the statement balance in full by the end of the grace period, you’ll pay interest on the unpaid balance.

For example: you have a credit card, and your most recent billing cycle ran from October 13, 2023, until November 12, 2023. During that period, you made $1,000 of purchases with your card. Your card has a grace period, so your payment due date is December 9, 2023. If you pay off the full $1,000 balance before December 9, your credit card company will not charge you any interest.

4. Interest is usually calculated daily

With credit cards, the issuer typically calculates the interest you owe on a daily basis based on your average daily account balance. Your daily average balance is listed on your credit card statement, but you can also calculate it by adding your daily total balances and dividing it by the number of days in your billing cycle. In most cases, the interest compounds, meaning the interest is added to your unpaid balance.

5. Credit card rates are variable

Unlike personal loans or car loans, which usually have fixed interest rates, credit card APRs are variable. With a variable rate, your card’s APR can change over time, affecting how much interest accrues and your minimum payment amount.

Most credit card companies base their rates on the Prime Rate, a rate set by banks that serves as a reference for loans and other forms of credit. Credit card companies typically charge the Prime Rate plus an added charge, which is known as its margin.

For example, let’s say a card’s APR is defined as “Prime Rate + 12.99%.” The Prime Rate is currently 8.50%, so the card’s APR would be 21.49%.

The Prime Rate can change over time, so your card’s rate will fluctuate along with those changes. Here is an example of how this credit card’s rate would have changed over the past year:

Managing credit card interest

Now that you know how credit card interest works, you can take advantage of these strategies for reducing or eliminating interest charges on your balance:

1. Pay the statement balance in full

As mentioned above, credit cards typically give you a grace period after the end of your billing cycle to make a payment before it will start charging interest. If you pay off the statement balance — not just the minimum payment required — by the listed due date, the credit card company won’t charge any interest.

If you have a rewards credit card, that means you can use the card and earn valuable points or cash back without ever paying interest charges.

2. Pay more than the minimum

Although paying off the statement balance in full is ideal, it’s not always possible. If that’s the case for you, aim to pay more than the minimum amount required. Increasing the payment amount — even by a small dollar amount — can make a significant difference.

For example, say you had $1,000 on a card at 22% interest and a minimum monthly payment of $30. If you only paid the minimum amount, it would take you over four years to pay off your card, and you’d pay a total of $1,559.61 — interest charges would add over $550 to your repayment cost.

You can afford to pay an extra $20 per month toward your debt, bringing your payment to $50. If you paid that amount every month, you’d pay off your balance in just over two years, and you’d pay a total of just $1,257.09. Increasing your payments would get you out of debt two years sooner, and you’d save about $300.

You can use the credit card pay-off calculator from 360 Degrees of Financial Literacy to see how much you can save by increasing your payments.

3. Request a rate reduction

If you’ve had a credit card for a while and have made all of your payments on time, you can contact your credit card issuer and request a rate reduction. Some companies will reduce the rate to reward and retain loyal customers. A reduction of even one percentage point can help you save money and pay off your debt faster.

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