How does credit card interest work?

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Credit cards are great tools, but it’s important to understand how they work to really be able to use them well. One key factor in understanding your credit card is knowing how your credit card interest works.

Credit card interest is communicated as a yearly rate known as APR, which stands for annual percentage rate. While the rate is annual, credit card interest is actually calculated on a daily basis and then charged monthly at the end of a billing cycle. In order to understand how much a purchase made with your credit card will really cost, you need to understand how interest is calculated and when it is applied.

How credit card interest rates work

Credit card interest is calculated based on your credit card balance. There are two kinds of credit card interest — fixed and variable. A fixed interest rate doesn’t change, but it is very rare to find a credit card with fixed interest. Most cards have variable interest, which changes according to an index.

The interest rate you’ve probably seen when looking at credit card offers is the purchase APR or the introductory APR. However, there are other interest rates that apply to your use of your credit account. Your issuer will have a different rate for purchases, balance transfers, and cash advances. There is also a penalty APR, usually the highest interest rate, that can be applied any time you go against the terms and conditions of your card agreement (like missing a payment).

Your creditor determines the interest rates for your credit account by looking at your credit history and annual income. When you apply for a credit card, your issuer will do a hard inquiry into your credit report. This will allow them to see your credit score, payment history, number of credit accounts, and other valuable information about your credit history. Your issuer will use this information to determine if they want to issue you a credit card, how much you will have for your credit line, and what your interest rates will be. People with higher credit scores usually qualify for lower interest rates.

One more thing to note is that interest rates on new purchases can be increased at anytime. The credit card company does, however, have to give you at least 45 days notice. Interest rates can also decrease at anytime. A decrease is usually a result of an improvement in your credit score or linked to a debt management plan.

When is interest charged?

Your credit card balance is considered a revolving balance because you are constantly borrowing from it and repaying it. If you have a revolving balance on your credit account, you will be charged interest on that balance every day until you pay the balance off. Once you have paid your balance off, it is no longer considered revolving. Credit accounts with zero balances also have the benefit of a grace period.

A grace period usually begins at the end of your last billing cycle and ends on the due date for your next payment. Not all cards have a grace period, but most do. Grace periods can last between 21 and 25 days. Cards that have a grace period are required to mail out bills at least 21 days before they are due to be paid. If you have $0 as your balance and no cash advances or balance transfers, new purchases won’t be charged interest during your grace period. However, grace periods only apply to accounts that are paid in full. Once you have a balance on your account it can take several months of full payment to recover a grace period.

How interest accrues

Credit card interest compounds on a daily basis. Compound interest is applied to your current balance and any purchases that post during a billing cycle. Credit card interest rates can be calculated by taking the APR and dividing it by 365 (the number of days in a year). This number tells you the amount of interest applied daily from month to month when you carry a balance on your credit card.

Let’s say you have an APR of 16.99 percent. That would place your daily rate at approximately .00047. If your balance at the beginning of your billing cycle is $433, your interest will compound on this amount until the end of your billing cycle. On day one,  your balance will raise to $433.20. On day two your interest will be calculated using this amount, increasing your balance to  $433.40. Interest will continue to compound in this way until you reach the end of your billing cycle. This example, however, assumes that no new purchases have been made during the billing period. However, let’s say on day three you add a purchase of $25.70 to your balance. That purchase will be added to your balance to give you a new balance of $458.90. Next, your interest will be calculated to make your final balance for day three $459.12. If no new purchases are made, your final balance at the end of the billing would around $465. If new purchases are made, they will be added to the balance and interest will continue to compound onto the new amount.

How to avoid interest

Making a purchase with a credit card has many benefits, especially if you are trying to build your credit or earn rewards. But having to pay interest means that the purchases you make cost you more in the long term. So how do you use your credit card and avoid interest? Well, you can avoid interest by taking one simple step — always pay your balance in full. If you make any purchases during your credit card’s grace period, make sure to pay them off before the grace period ends.

If you’re simply dealing with paying off new purchases, this method will work for you. However, if you are already dealing with a high balance on your credit card, you may need a different solution. It may be time to transfer your balance to another card with an introductory period with zero percent interest. This would allow you time to pay off the balance at no interest. Just make sure you have a plan for how you will do that before you do the transfer. And keep in mind that most balance transfers do involve a fee.

Once you have your balance at $0, it’s important to maintain good payment habits to keep interest at bay. Always make sure you have a repayment strategy for any purchases you make, and keep tabs on your billing cycles so that you can make sure you pay off purchases before the grace period ends. And remember, interest is compounded daily. If you have a balance of $50 on your account from a previous month that you pay off before the end of the billing period, you will still owe the daily compounded interest. This means that when you get your bill, you will see the interest as your balance due, even though you’ve paid the principal ($50). If you don’t pay this amount, it will gather interest. This is why it takes at least two billing cycles to clear a balance and regain a grace period.