Credit card interest is the cost of borrowing money from your issuer. But depending on how you use your card, you may never have to pay it.
If you pay your balance in full every billing cycle, you won’t ever be charged interest. But if you carry a balance from month to month, an interest charge will be factored into the minimum amount you’ll be required to pay to keep your account current.
Unlike installment loans, credit card interest can come in many forms and is calculated based on a unique formula. Whether you’ve had credit cards for years or are planning to get your first one, here’s everything you need to know about credit card interest, including how to avoid it.
See related: Which credit card should I get?
What is credit card interest?
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The amount you pay in interest can vary based on the type of credit account you have, whether there’s collateral involved and your creditworthiness.
For example, a mortgage loan typically carries a much lower interest rate than an unsecured personal loan because if you default, the mortgage lender can foreclose the home and sell it to recoup its losses. With the unsecured personal loan, there is no collateral to repossess.
With both installment loans and credit cards, interest is calculated as a percentage of the account balance. That percentage is annualized to give you an annual percentage rate (APR).
Credit card interest is different from other types of loan interest because while your account may have an APR attached, it doesn’t necessarily mean that you’ll pay it. Most credit cards offer a grace period between your statement date and due date, during which you can pay off your balance from the previous month interest-free.
Credit cards also come with a handful of different types of APRs, depending on how you use the account.
How is credit card interest calculated?
Credit cards typically have variable interest rates that fluctuate based on the going prime rate. The prime rate is based on the federal funds rate set by the Federal Reserve and is a benchmark that lenders use to set for home equity lines of credit and credit cards.
This means your APR can go up and down over time. It’s also important to note that credit card issuers typically calculate how much interest you owe daily rather than monthly.
To calculate how much interest you’re actually paying on your credit card, you’ll first need to convert your APR into a daily interest rate.
- To do this, credit card issuers divide your APR by either 360 or 365. For example, if you have a 20% APR, your daily periodic rate could be 0.0556% or 0.0548%, depending on which bank or credit union issued your account.
- You’ll then calculate your average daily balance. To do this, start with your unpaid balance from the previous statement period (if applicable), then add up your balance at the end of each day during the current statement period. Combine them all and divide the sum by the number of days in the billing period to get your average daily balance.
- Once you have both your average daily balance and your daily periodic rate, multiply the two, then multiply that result by the number of days in your billing cycle.
- For example, let’s say your average daily balance was $2,400 over 30 days, and your card issuer uses 365 days to calculate the daily periodic rate. Multiply $2,400 by 0.0548% to get $1.3152, which you’ll multiply by 30 days to get $39.46.
See related: How to read and understand your credit card statement
How are credit card interest rates determined?
While some credit cards offer a single APR to all cardholders that are approved, most provide a range of APRs. The APR you receive is based on the type of credit card you apply for and your creditworthiness. If you have a stellar credit history, a low debt-to-income ratio and other favorable attributes, your chances of getting an APR on the lower end of the spectrum increase.
However, if your credit history has some issues or your debt payments take up a large portion of your gross monthly income, you could end up with a higher interest rate.
People with limited, fair or bad credit may not even qualify for some of the better credit cards that are available. Credit cards for these types of credit profiles typically carry higher APRs. For example, the average interest rate on a card for people with bad credit is 25.30% APR as of April 7, 2021. In contrast, the national average is 16.15%.
See Related: How do credit card APRs work?
How to avoid paying interest
While credit cards typically carry higher interest rates than mortgage, student, auto and personal loans, one of the benefits of having a credit card is that you can get away with never paying interest at all.
There are a few ways you can achieve this goal:
- Pay your bill on time and in full: Credit card purchases typically get a grace period of at least 21 days between the end of each statement cycle and the due date for that period. If you pay off your balance in full by the due date every month, you’ll never pay a dime in interest.
- Take advantage of 0% APR promotions: If you need to finance a large purchase or want to transfer a balance from another card, look for 0% APR credit cards and balance transfer credit cards that allow you to do it interest-free. Just keep in mind that many balance transfer cards charge a balance transfer fee, so the process isn’t always entirely free.
- Avoid transactions with no grace period: Cash advances are rarely a good idea because they’re expensive – you’ll often pay a higher APR plus a cash advance fee – and there’s no grace period. Try to avoid them completely, if possible.creditcards.com