How does credit card interest work? If you were asked this question, would you be able to answer it?
Most people could not so it is ok if you can’t. Nevertheless, after reading this you won’t be able to say that anymore!
At the end of 2021, 40% of Americans carried a balance on their credit cards from month to month.
36% used their card but didn’t carry a balance and 24% had credit cards but didn’t use them (Bankers Association Data Survey).
How AMAZING would it be if you were part of the 36% or 24% crowd?
I’m here to tell you that you can be.
The first step is learning how credit card interest works and how to calculate it.
“What we do today, right now, will have an accumulated effect on all our tomorrows.”
– Alexandra Stoddard
In other words, the more you know about interest the easier it will be to determine if a new purchase is really worth charging.
Or how long it will take to pay off your credit card balance.
We will not cover interest rate negotiating in this post.
Unless you have paid off your balance, have a high credit score, or have a long history of paying on time.
A lower interest rate would not be granted by the bank.
Don’t worry, I kept the explanations short with minimal jargon so you leave this post a credit card interest Guru!
What Is Credit Card Interest
Using a credit card is just like taking out a home or auto loan with a bank.
Interest is what the bank charges you for borrowing their money.
Credit cards have become such a large part of our society that no one really views them as a bank loan.
How Does Credit Card Interest Work
For the sake of keeping things simple, if you pay your bill in full by your statement due date you won’t pay interest.
The bank wants to make money from you so they always set your minimum monthly payment lower than what you actually owe.
They are encouraging you to roll over part of your purchase balance to the next month.
Once part of the amount rolls over to the next month you will be charged interest.
In addition, if you carry a balance on your credit card for multiple months then you are charged interest on the purchase balance as well as the interest from the previous month.
This is called compounding interest.
What Is a Grace Period?
This is something that can buy you some time before you are charged interest.
A grace period is the length of time the bank gives you to pay your bill in full before they start applying interest.
The interest-free grace period is usually 21 days long. It starts on the statement date and lasts until the payment due date.
Some banks don’t offer a grace period and they are not required to.
You’ll want to check with your bank to see if your credit account has one.
If you pay the minimum payment, you will be charged interest on the remaining balance the next month.
When Does Credit Card Interest Apply
In the first month of a rollover balance, you’ll see a monthly interest rate applied.
If the same balance rolls over again, you will be charged interest on a daily basis.
When you have roll-over balances, you will not receive a grace period for new purchases.
In addition, with the rollover balance, your total balance will continue to grow every month even if you do not make any new purchases.
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When Are Credit Card Fees Charged
Aside from interest, there are credit card fees applied to your account. Below are some of the most common.
Annual Fees (known as APR)
These are charged to your account once per year. The timing depends on the bank.
Chase bank charges my annual APR fee in January regardless of my carrying a balance.
Late Payment Fee
Just as it sounds, this fee occurs when your payment is late on your account.
As long as you pay your minimum balance by the due date each month, you will never see this fee.
Balance Transfer Fee
This is a fee you are only charged on balances transferred from one credit card to another.
Usually, the fee is 3-5% of the balance you are transferring.
Over-the-limit Fee
You are charged a fee every month your balance is over your credit limit.
Compounding interest can cause this to occur quickly if your interest rate is high.
Returned Payment Fee
This fee is also applied when your credit account is over its limit or if your account cannot fully process a transaction.
Banks use this fee for a multitude of reasons. I’ve seen this fee applied to frozen credit card accounts.
If it ever appears on your statement, reach out to your bank to find out why.
How to Calculate Your Credit Card Interest
I know the idea of doing math may not excite you.
However, knowing how the bank calculates your interest rate will help you determine if that next purchase is worth buying on credit.
Calculating Your Monthly APR
- Find your interest rate and balance on your current credit card statement
- Divide your interest rate by 12 months to get your monthly rate
- Multiply your monthly rate by your current balance
Calculating Your Daily APR
- Again, find your interest rate and balance on your current statement
- Divide your interest rate by 365 days to get your daily rate
- Multiply your daily rate by your current balance
In order to see the full effect of making a new purchase on your account, add the new purchase dollar amount to your current balance.
Then use the new number to calculate the daily APR rate.
This will show you how much your interest will increase.
Keep in mind the monthly APR rate will only apply to a new purchase if your account balance is increasing from zero.
The rest of the time, you will be charged the daily APR rate.
How Your Credit Card Minimum Payment is Calculated
How your minimum payment is calculated each month will vary from bank to bank.
You’ll want to look at each credit card agreement to see how each account is calculated.
Banks typically use one of two methods.
- A flat percentage of your entire current balance, the percentage can range from 2% to 4%.
- A combination of interest, fees, and percentage of your entire current balance, the percentage is usually around 1% and the fee $25 or $35.
To anticipate how much your minimum balance will be if you make a new purchase use option 2 for the calculation.
I recommend using the Daily Interest APR (see above for how to calculate), a $35 fee, and 1% of your current balance plus the new purchase total.
The reason is because it will calculate the highest estimated possibility for your minimum payment.
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It’s better to be prepared to pay a maximum amount rather than the lowest.
The last thing you want is a surprise on your next billing statement.
This guestimation is only designed to help you make informed credit card purchases.
You will also learn which credit cards you prefer to use for large emergency purchases since you will find which ones are the cheapest to use.
Can a Credit Card Have More Than One Interest Rate or APR
The short answer is yes and you can be charged different interest rates at the same time.
It’s typical for all credit card accounts to have different rates and APRs depending on the activity in your credit card account.
Some straightforward rates you may already be aware of are APR, new purchase interest, balance transfer interest, and cash advance APR.
When your credit card account has purchase activity and balance transfer activity on it, you will be charged two different interest rates each month.
Usually, the balance transfer interest is higher than the new purchase interest.
Also, keep in mind; banks usually apply your monthly payments to the new purchase amount before the transferred amount.
I learned this the hard way when I didn’t pay off a transfer balance before the 0% APR trial ended.
I was paying 30% interest every month on the remaining transferred balance while paying 16% on new purchases.
The 30% filled up my credit limit pretty quickly.
The only way to get rid of the higher interest is to pay the credit card off in full.
More Articles You May Be Interested In:
Should I Use All of my Savings to Pay Off my Credit Card Debt
How do I Get Out of Debt With Bad Credit
When Credit Cards Help Your Finances
Concluding Thoughts
I know the basics of credit card interest, now what do I do with it?
Start using this knowledge as a ruler for your future purchases. Is buying that new purse, laptop, or phone really worth charging?
You can also use this knowledge to map out a timeline of how long it will take you to pay off your credit card balance in full.
The smaller your balance gets the faster you will pay it off for good.
In 2019, I stopped charging new purchases to my Chase credit card with a $6,500 balance.
By 2022, my balance was paid in full.
Now I’m part of the “pay off my monthly balance in full” club.
If I can do it, I know you can too!
If you are looking for strategies to get your finances under control check out the links below.
I just finished a series on customizing your perfect budget.
How to Create a Budget for Beginners
5 Types of Budgets for Beginners
How to Create a Biweekly Budget that Actually Works
Discover 9 Easy Steps to Create Your Cash Envelope System
How to Create a Values-Based Budget Using 5 Easy Steps
Happy Reading!
References
https://www.lendingtree.com/credit-cards/credit-card-debt-statistics/#credit-card-debt-state
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