How Credit Card Interest Works

Credit cards can be useful, convenient tools or they can be debt-inducing machines that can drain bank accounts and ruin a borrower’s credit. The difference, in many cases, comes down to borrowers understanding how lenders calculate interest.

Before you sign up for one of the many credit card offers you get in the mail, understand exactly how that interest rate can change and how much it will add to your balance every month.

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APR Definition 

APR stands for “annual percentage rate,” and it’s the most critical component of credit card interest. As the name implies, it’s the standard rate you’ll pay for purchases you make on your credit card.

The rate is calculated over the course of the year, but you pay every month. A good analogy is to think about purchase APR like the miles-per-hour standard used to determine how fast you’re going in a car, according to Discover. Miles per hour shows how fast you’re going by calculating how many miles you would cover at a set speed in a single hour. But if you divide it by two, you’d get the rate for miles per half hour.

Divide it by 60, and that’s your miles per minute. Likewise, lenders figure out how to calculate credit card interest per month by dividing the APR into smaller segments.

How to Calculate Credit Card Interest

To calculate your daily interest rate, simply divide your APR by 365. To find how much you owe, multiply that rate by your current balance. Through a process known as compounding, your credit card company adds that amount to your balance every day and calculates a new balance the next day.

So, if your APR is 15 percent, your daily rate is .041096 percent. If you spend $1,000 on the first day of the month, your balance will be $1,000.41 on the second day. By the end of the month, your balance will be $1,013.

Lenders charge you interest at the end of the billing cycle every month. If you pay your balance in full before your due date, you’ve settled up with your issuer within what’s called the “credit card grace period.” In this case, you avoid credit card interest altogether for that month and earn yourself a free, short-term loan. Issuers make money on the balances their customers carry from month-to-month and the interest charged on those balances. 

Related: 10 Things You Should Never Put on a Credit Card

Balance Transfer APR and Introductory APR

Many credit card offers come with a special introductory rate or balance transfer offers. Credit card issuers offer these deals to entice borrowers to open new accounts, but borrowers could benefit as well. Balance transfer cards are regular credit cards that offer a very low introductory APR for a certain period of time, often 12 months, before the regular interest rate kicks in. 

During that introductory period, however, you can transfer balances from high-interest cards to pay off at the lower balance transfer APR rate. You’ll also enjoy the convenience of paying one bill on a specific due date instead of paying off several cards every month.

Common Credit Card Fees and Penalties

Interest charges aren’t the only way you pay when it comes to credit cards.

• If you accept an issuer’s offer of a balance transfer, there’s likely to be a one-time balance transfer fee (typically 1 to 5 percent).
• Many issuers allow you to use the card to get cash at an ATM the way you would with a debit card (or cash advances).
• A late payment will also result in a fee, even if it’s not reported as a delinquency to the credit agencies.
• Many cards also charge over-the-limit fees, foreign transaction fees and annual fees.

Avoid Credit Card Interest

When you understand how interest works, you can avoid credit card fees, penalties and even interest payments altogether. The key is knowing your APR and understanding how it’s compounded every day and added to your balance at the end of the month. Know your APR, know the potential fees and keep them all in mind every time you swipe. Remember, the only way to avoid credit card interest is to pay your balance in full every month.

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