How Does Credit Card Interest Work?

Have you ever wondered why credit card debt seems to accumulate so quickly? You didn’t pay your credit card balance in full at the end of the month, but you used your card for only a handful of purchases. Yet still, your credit card debt seems higher than it should be. One of the reasons credit card debt can be so frustrating and expensive relates to how credit cards work. Credit cards charge interest when you don’t pay off your full balance by the due date each month. And this interest adds up faster than you may think, especially if you don’t know how credit card interest works. Here’s what you need to know about credit card interest, how it works and what you can do to avoid it.

What Is Interest?

Interest is essentially the price a borrower pays for the privilege of borrowing money. In fact, charging interest is the primary way credit card companies earn revenue. If obligations aren’t paid back in full on time — by the due date on each month’s statement — interest accrues based on the average daily balance remaining on a card. This amount is then due in addition to the purchase balance. For example, if you owe $125 on your credit card and only pay the monthly minimum of, say, $25, interest will accrue on the additional $100 that remains on your card from one month to the next. If you charge another $125 the following month, your next bill due will include:

• $100 remaining from the prior month
• $125 in new charges
• Any interest that accrued on the existing $100 balance

When you carry, or revolve, a credit card balance from month to month, interest is charged on a daily basis, and it affects both your existing balance and any new purchases that post to your account. The interest you’re charged one day also becomes part of the balance accruing interest the next. In other words, credit card interest compounds daily. That, combined with the fact that credit cards are known for having high rates, is why credit card debt is so expensive.

What Is an Interest Rate?

Interest rate is a figure that determines the amount of interest that accrues over the course of a month when a credit card balance isn’t paid in full. While expressed as an annual amount, cards accrue interest over each statement period. Credit card interest rates are determined by a few different factors, including:

• Nature of the card in question
• Credit limit
• Your credit score
• Your credit history

Calculating Interest

To calculate a rough estimate of interest due, take your total interest rate and divide it by 365, or the total number of days in a year. If your rate is 20 percent, this is equal to 0.054795 percent per day. Then, multiply this rate by the days outstanding. For example, if your credit card was due last month with an average balance of $100 and you haven’t paid it by the time it’s assessed on the next statement date, you’ll accrue roughly 30 days of interest, or $1.65. It is important to note that credit card interest compounds. This means that the interest you’re accruing will earn interest if you don’t pay it off on the following statement. While a 20 percent interest rate implies $20 of accrued interest over the course of a year for a balance of $100, this number will be closer to $22 with the effects of compounding.

APR vs. Interest Rate

When it comes to credit cards, interest is usually expressed as an annual rate, called an annual percentage rate, or APR. It’s important to note that the credit card interest rate and the credit card APR are terms that are often used interchangeably, but they’re not exactly the same. First, the interest rate specifically refers to the rate at which interest itself accumulates. Second, APR includes both interest rate and any other fees or charges associated with either use of your card or carrying a balance. For this reason, interest rate and APR may differ slightly. The larger the difference between the interest rate and the APR, the more fees you’re being charged on top of interest. According to CreditCards.com , the national average credit card APR is 17.27 percent, as of Nov. 11, 2019.

Different Kinds of Interest Rates

Interest rates can come in a few different shapes and sizes. On a broad level, an interest rate can be divided between ones that charge a fixed APR or a variable APR. A fixed APR means the interest rate charged generally stays the same. With a variable APR, the interest rate fluctuates based on an underlying index, usually the prime rate. Credit cards with a variable interest rate add a margin on top of the prime rate, resulting in the variable APR for your credit card. Credit card interest rates have another layer of variety. For example, many cards include few different APRs depending on how the credit card is used. Here are some different credit card APRs:

• Purchase APR: The interest rate that applies to purchases not paid off in full by the due date
• Cash advance APR: The interest rate that pertains to cash borrowed against credit
• Balance transfer APR: The interest rate that applies on the transfer of a balance from one card to another
• Penalty APR: Additional interest that may apply if the borrower defaults on the terms of the credit card
• Intro APR: A temporary promotional rate, usually 0%, that applies to purchases made within a defined time period, typically the first 12 to 24 months 

Before opening a new credit card, it’s important to review the various kinds of interest that may apply. For instance, if you plan to open a zero percent purchase APR credit card for the purpose of a balance transfer, be sure the balance transfer APR is zero percent as well. By understanding how credit card interest works in this regard, you can turn credit card usage to your advantage.

How to Avoid Interest

It is absolutely possible to have a credit card and never have to pay interest. Perhaps the main reason why this isn’t more widely known is because so many Americans carry a revolving balance from month to month. Here are some basic ways to avoid paying credit card interest:

• Paying the statement balance in full by the due date. If there’s no balance on which interest can accrue, you won’t face an interest payment on top of your purchases. If you can’t afford to pay the whole balance, pay as much as you comfortably can to reduce the interest that will apply. Paying down more of your card balance can also help your credit score.
• Take advantage of 0% APR offers. Many new credit cards offer 0% introductory APR to new cardholders for a period of 12 to 24 months. If you’re planning to make a large purchase that may not be feasible to pay at once, it could be a good time to open a new 0 percent APR card to save on interest.
• Stay vigilant. It’s easy to let credit card spending spiral out of control so be sure you know what you can afford to spend, your limit and your interest rate. Keep an eye on your spending by downloading your bank’s app and make it a habit to check your balance daily.

Paying your statement balance in full by the due date is the primary way to avoid interest charges.

Why Can You Get Charged Interest With No Balance?

However, it is not uncommon for people to receive a credit card bill that includes interest even after they reduced their credit card balance down to zero. Getting charged interest while having no credit card balance occurs because of the credit card billing process. For example, you pay off only part of your credit card balance by the due date, say, April 30, and owe $1,000 by the end of next month, May 31. Every day that $1,000 accumulates interest, so even if you don’t use your card at all in May and pay off the $1,000 in full, for the next billing period which starts June 1, you’ll have a credit card balance equal to the interest accrued over the course of May.

The Bottom Line

Credit card interest isn’t fun, but it can be avoided. A thorough understanding of interest rates, interest calculations and the different forms of APR can help you navigate the waters of credit card usage with ease.