If you have a credit card, you’ve heard of interest. But you may not know exactly how it works. Many consumers operate without actually knowing how the interest on their credit cards is calculated. But it is important to understand how interest works, so you can be an educated consumer and use your credit card effectively.
What is an APR?
Your interest rate is also known as your annual percentage rate (APR). For most people, the interest rate falls between 10.99% and 29.99%. There are many introductory promotions from credit cards that offer 0% intro APR on purchases and balance transfers for a certain period of time, so consumers can get a lower or 0% interest rate when signing up for their credit card. However, even with the cards that have special introductory offers, interest rates normally switch between 10.99% - 29.99% after the introductory period. There is no set APR for each credit card; your interest rate is determined based on your credit history. So, if you have a low credit score, you will have a higher interest rate.
Related Article: What's the Best Zero Interest Credit Card Offer Right Now?
What is the Difference Between a Fixed and Variable Interest Rate?
There are two types of interest rates: fixed and variable. Fixed rates are interest rates that will remain at a predetermined rate, while variable rates fluctuate based on the market. Most credit cards work at a variable interest rate. With a variable interest rate, your APR is tied to an index, such as the prime rate. The prime rate in the US is set by the Federal Reserve; when the prime rate is raised or dropped by X%, the interest rate of a variable rate card will change by the same X % within 30 days. The variable rate is made up of this index plus a margin. For example, if your credit card terms say your rate is “Index +10.99%” and the prime rate is at 4%, your card’s interest rate is 14.99%. As a result, your interest rate changes periodically.
When Does Interest Start to Accrue?
If you pay off your credit card balance in full each month, you do NOT have to worry about interest charges. Interest charges only accrue when you do not pay in full. So, if you only make the minimum payment and you start racking up a credit card balance, you will start having to pay interest charges.
How Do Interest Charges Work?
Once you have an outstanding balance, you will be charged an interest fee (also known as a finance charge). There are many different ways financial institutions calculate finance charges. Here are the most commonly used methods:
·Average Daily Balance: The majority of credit card companies use an average daily balance to calculate your credit card interest charges. The company tracks your balance day by day. Once the period is over, they will take the average of the daily totals and multiply this number by the monthly interest rate to determine your interest.
·Adjusted Balance: With the adjusted balance method, the balance at the end of the billing cycle is multiplied by the monthly interest rate to determine your interest. This can actually be favorable to cardholders, because it results in the lowest finance charge.
·Previous Balance: This is the reverse of the adjusted balance method. Instead, the balance at the start of the previous billing cycle is multiplied by the monthly interest rate. This rate favors the credit card issuer, because you are still being charged interest on your balance a whole period after you pay it.
·Two-cycle Average Daily Balance: With this method, the balances in your account during each day of the last two billing cycles are added together, but interest is charged on that amount only over the current cycle.
Related Article: Deferred Interest Credit Cards: Why They May Be Dangerous to Consumers
In Conclusion
What you pay varies depending on your balance, the interest rate, and the way your finance charge is calculated. Know how interest works and understand your credit card’s terms regarding interest rates. But if you pay your balance in full each month, you won’t have to worry about extra charges!
