How Does Interest on Credit Cards Work?

If you have an outstanding credit card balance (money you haven’t paid off yet), you might be paying hundreds of dollars in interest each year. Perhaps you’ve already been surprised to see that your credit card number has risen month after month. Interest can mount up faster than the pounds after Thanksgiving if you’re not careful.

But how does interest on credit cards work? Keep your seat warm as we go over the ins and outs of credit card interest and how to avoid falling into debt.

What Is Interest in a Credit Card?

The annual percentage rate is this. The annual percentage rate (APR) is the interest rate that a credit card business charges you. When you buy something with a credit card, whether spectacles or an iPad, you’re borrowing money from the credit card company. They’re not providing it for free, though; they’re adding a percentage of whatever you spend to your debt, so you’re repaying more than you’re borrowing. That is curiosity.

The annual percentage rate (APR) is charged monthly despite its name. Because the money is still technically on loan to you, you’ll be charged interest if you don’t pay off your credit card account by the end of your monthly billing cycle.

Maybe you’re thinking, “Well, I’ll just pay off my credit card debt each month to avoid paying interest.” Let us bring you to a halt right there. Only 47% of Americans using credit cards paid out their debt each month in 2018. That isn’t the best possible scenario.

The bottom line is that interest is money you pay only for borrowing. Thank you, but no!

What is the formula for calculating credit card interest?

It’s time to dust off your algebra books, sharpen your pencils, and get out your graphing calculator. Just joking! You don’t need to be an accountant to figure out how much interest you’re paying, but basic math is required. But don’t worry; we’ll guide you through it.

1. Determine your APR.

It’s time to find out your credit card’s annual percentage rate. Keep in mind that you may have more than one if you have numerous cards. For this example, let’s use a credit card with a 15% annual percentage rate. When we divide that by 100, we get 0.15 as a decimal. See? So far, it’s been relatively simple.

2. Convert the annual percentage rate to a daily interest rate.

Divide the result by 365, the number of days a year (unless it’s a leap year, that’s another story). Hey, that’s a meager figure! However, that is only the daily interest rate. We’re not looking for that number.

3. Determine the balance of your account.

Assume you just spent $2,100 on a new living room set credit. This is your current account balance. Your current account balance can be seen on your most recent credit card statement if you’re curious (which you should get in the mail or see online).

4. Determine how much you pay each day.

Multiply the daily interest rate you calculated in step two by the account balance. If you let your balance rollover, you can pay interest (in dollars). In this case, $2,100 multiplied by 0.00041096 = 86 cents a day in interest. But wait, there’s one more factor to consider when calculating your credit card APR.

Remember to factor in compound interest.

For this example, we’ve been utilizing simple interest so far. However, because most credit card issuers calculate daily charges using compound interest, your balance will grow. Compound interest is computed on the principal plus any previously added interest, whereas simple interest is calculated on just the principal (original amount). It’s a vital interest on interest.

Compound interest can be difficult to calculate (which is fortunate for credit card companies), but it adds up quickly. That furniture set would cost you $26.05 each month with daily compound interest. And just in interest, that could equal an extra $339.78 per year!

A $2,100 living room set for almost $2,500? It doesn’t take Bob Barker to see that the price isn’t right. When you do the arithmetic, you’ll realize how much interest costs you in dollars, not just annually but monthly, when the numbers may hit you in the gut.

If you stop paying minimum costs, the claim will raise your account balance, increasing interest.

How to Calculate APR

Credit card firms may spin a wheel to determine your annual percentage rate. However, there is some rationale behind the figure.

If a credit card company lends you money, it wants to know that you will repay it. If you are more likely not to pay off your credit card account each month, your interest rate will almost certainly be higher. As a result, your interest rate is usually determined by your credit score and income, as these are indicators that you’re more likely to pay off your bill on time.

However, if going into debt is the only way to prove you’re “worthy” of borrowing money, it’s not something you should aspire towards. Consider APR to be your “credit riskiness.”

And as previously said, different credit cards have other forms of APRs. A quick summary of each APR type follows:

APR that varies

The interest rate on a variable APR loan might alter. When the prime rate changes, your credit card’s specific interest rate.

APR fixed

However, there are several circumstances in which a credit card issuer may increase your rate, such as if you are more than 60 days late on a payment.

APR Purchase

You will be charged interest when you don’t pay off your credit card debt in full by each month’s due date.

APR on Cash Advances

When you borrow against your credit limit, you’ll be charged a cash advance APR. There is no grace period (the time between the end of your billing cycle and when your payment is due), and the interest rate is often greater than purchase APRs.

APR Penalty

When you exceed your credit limit or make a late payment, you will be charged a penalty APR.

APR introductory

As a benefit of acquiring a specific credit card type, credit card firms frequently provide a reduced introductory APR. However, these low initial APRs typically increase after a set time.

APR for Balance Transfers

A credit card operator may offer a low balance transfer APR if you transfer a balance to another. However, like initial APRs, these usually don’t last long and soar back up once the intro is finished.

APRs of many kinds

However, reward credit cards frequently have higher interest rates. Did you believe the freebies were genuinely free?

Assume you have a credit card that gives you 3% cashback. To receive $3 back, you would have to spend $100. Really? That is not a winning strategy. That’s what it’s like to be a member of a system that profits from millions of people. Rewards are simply a means of encouraging credit card users to spend more on their cards each month, increasing the likelihood of paying them back with interest.

Don’t get too comfy, even if your APR is low. Credit card firms can still increase your interest rates on new cards, and in some situations, they can even hike rates on existing balances, so no APR is guaranteed.

Don’t play this game, please. Credit cards aren’t worth your time or your money.

What is the average interest rate on credit cards?

2. That’s about a quarter of your total balance! That might build up to a lot, depending on how much money you have. Even if you only pay $100 each month, you’ll owe an extra $25 at the end of the year—and let’s face it; most individuals have considerably more than a Benjamin Franklin on their credit card statements.

In 2019, the average annual percentage rate (APR) for credit card accounts was around 16.88 percent, up over 4% from five years earlier.

3 That’s after the Federal Reserve cut rates for the first time in nearly a decade!

Depending on your card type, your interest rate may be higher or lower than the national average APR. But, with the typical American household in credit card debt of $7,136, you better believe it.

How to Save Money on Credit Cards?

Okay. You undoubtedly want to know how to prevent credit card interest now that you understand how it works. Here’s the dirty little secret: The most straightforward approach to avoiding credit card interest is ultimately paying it off.

You don’t want to pay interest on anything because you’re spending money for the “luxury” of borrowing. Instead, stop borrowing and start saving money to pay for things. It eliminates the danger of having to pay interest entirely.

But what if you already have a loan for that new couch, home entertainment system, or car? Here are some steps to move out of the danger zone if you have credit card debt or a balance that will put you into interest territory.

As soon as possible, pay off your balance.

While making minimal credit card payments on time will help you avoid incurring interest, it’s still risky. One unexpected event can prevent you from paying your bill in full. You could find yourself buried in a pile of interest before realizing it. Instead, paying your credit card amount as soon as possible is the best approach to prevent paying interest. That means stepping up your game! And because it helps you change your behavior, the debt snowball method is the quickest way to deal with your credit card bills.

The following is how it works:

Step one:

List your debts from smallest to most significant, regardless of interest rate (we know we’ve been preaching about interest all along, but trust us when we say it doesn’t matter in this phase). Pay the bare minimum on everything except the smallest balance.

Step two:

With everything you’ve got, go after the tiniest debt. Once that debt is paid off, apply that payment (along with any extra cash you can find in your budget) to the second-smallest debt while making minimum payments on the first.

Step three:

The more you pay off, the more money you have available to pay off further debts, like a snowball rolling downhill.

The debt snowball strategy works because it builds momentum and keeps you motivated as you pay off your bills.

And take attention: the faster you work on your debt snowball, the sooner those credit card payments—and the interest associated with them—will no longer strain your monthly budget.