Understanding Credit Card Interest

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Understanding Credit Card Interest

Credit cards have changed the way we all shop. Rather than paying for a purchase out of your current monthly budget or the cash you have on hand, you can pay for it over time, plus interest.

But how well do we understand what that “plus interest” means? Depending on how you handle making credit card payments, you might go from being a 'savvy shopper' to someone who overpays for things they buy.

Interest is the price you pay for borrowing money. Credit card issuers typically state their interest rate as an Annual Percentage Rate or APR. You pay interest at the APR rate when you fail to pay the entire balance before the due date.

Whenever you fail to pay your entire balance before the due date, the credit card company imposes interest on the unpaid amount, which adds more to your debt. If you fail to pay your balance the following month, you'll pay interest on top of your interest. Your credit card balance can quickly grow if you consistently leave an unpaid balance at the end of each billing cycle.

Credit card interest is charged monthly, based on your outstanding balance. Each time you carry forward a credit card balance, the interest gets added to the balance based on your APR. Your credit card statement will list what that APR is.

Calculating your monthly APR rate is relatively simple:

  1. Divide your current APR by 12 (for the 12 months of the year).
  2. Multiply the resulting rate by the amount of your current balance.

If you currently owe $1,000 on your credit card and have an APR of 18%, you can calculate your monthly interest by dividing the 18% APR by 12 to get 1.5%. If you multiply that 1.5% by your balance of $1,000, you get $15.00. That $15.00 gets added to your balance.

Your credit card company may sometimes calculate interest with a daily periodic rate. In that case, divide your APR by 365 instead of 12 to get the daily rate. Multiply that by your outstanding balance. In the above example, you would have a daily APR of 0.049% and a daily interest charge of $0.50.

In both cases, it will pay for you to pay your balance off each month so that you avoid those additional interest charges.

Types of Credit Card Interest

Credit card companies tend to charge a variable interest rate based on fluctuating market conditions. As a result, fixed interest rates are relatively uncommon except for personal loans and mortgages.

Credit card issuers may also have different types of rates, depending on how you use the card and whether you're an existing customer or not. Interest can be the following types:

  • Introductory APR. Most companies will attract customers to sign up for a new credit card by offering a 0% APR on balance transfers or purchases. That introductory term can run anywhere from six to 24 months.
  • Balance Transfer APR. This APR applies when you transfer balances from existing credit cards or loans.
  • Purchase APR. This rate will apply whenever you purchase using your credit card.
  • Cash Advance APR. When you use your credit card to get cash instead of purchase, you'll incur a cash advance APR. Typically, cash advance APRs are higher than your purchase APR while not having a grace period. Usually, you'll have to pay interest from the transaction date.
  • Penalty APR. Penalty APR's interest rate is the highest rate issued by your credit card company. You'll incur this rate if you fail to pay your balances before the due date.

For almost all cases, the APR will depend on your credit score. A good credit score (720 or more) can help you qualify for a lower rate since your lender will consider you a lower risk. On the other hand, having a poor credit score will increase your interest rate.

Factors Impacting Your Interest

The following factors can influence your credit card's interest rate:

Prime Rate

Typically, the Federal Reserve sets a 'prime rate' that credit card companies use to establish the rate of interest to be charged for their credit cards.

Your credit score, credit history, and other factors can also determine your credit card's interest rate.

Hard Credit Inquiry

The issuing credit card company will perform a hard credit inquiry based on your credit report whenever you apply for a card. The credit inquiry will look at your history of payments, credit score and the number of credit accounts you own. Due to these criteria, it is best to improve your credit score before applying for a new credit card.

Ways to Lower Your Interest

Credit card interest can easily drain your finances while pulling you into more debt. Here are some tips for lowering your credit card interest while managing your cards:

  • Pay your entire monthly credit card balance to avoid penalty interest charges.
  • Use credit cards with lower APRs to reduce interest charges. Utilizing introductory credit cards with 0% APR can help you manage your balance better.
  • Try using a zero-interest balance transfer credit card and move your balances to it. This type of credit card will give you more time to pay your balance off to avoid interest.
  • Pay off your balances early in your billing cycle to avoid interest charges. In addition, you can control your credit card expenses to lower your average daily balance during the month.

Credit cards are great for adding flexibility to your finances while earning rewards. Paying off your entire monthly balance will help you avoid unnecessary credit card interest expenses.

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