Understanding interest rates on a credit card is harder than it seems. What is the real interest rate? How often is it applied, and what does it really cost? Credit cards are usually advertised by their APR (Annual Percentage Rate). What does that mean?
Interest is the cost of having access to credit—it’s the fee you pay for using the bank’s money instead of your own. The longer you go without repaying the balance owed, the more it will cost you in interest.
APR on a credit card refers to the yearly interest rate on a card. But it’s not quite that simple. Interest is typically calculated every day, and you are charged every month. The “annual” rate is not something you’d ever pay, because if you only made one payment per year, you’d be paying lots of late fees on top of the balance and interest (plus the debt would have defaulted after x-amount of days and probably have been transferred to a collection agency, severely impacting your credit score in the process).
Calculating interest from your APR
The average APR on a credit card in the US last year was 16.86% (according to the Federal Reserve). If you owed $1,000, what would that APR really cost you?
First you divide the annual rate by 365 to come up with a daily rate. So .1686 ÷ 365 = .0004619178. That is the percentage of interest you’d be charged each day.
Confused yet? You also have to remember that the balance is good throughout a monthly billing period. So on day 1 of the month you owe $1,000 on a card with 16.86% interest. Then you are charged approximately .46¢ in interest. ($1,000 x 0.0004619178% daily percentage rate).
Then the balance on the card for day 2 is $1,000.46, and the balance on day 3 would be $1,000.92, and so on. By the end of the month, you’d have a balance of $1,013.34. If your debt is compounded monthly, starting on day 1 of month 2, you’re charged .0004619178% of the new higher balance.
That’s assuming you didn’t use the card at all during the month. If you did, you might increase the interest charged every day, because many credit card companies base your interest on your average daily balance. So if you spent $30 on top of the $1,000 you started with, the average daily rate would be $1,001, and that’s what your daily periodic rate would be charged against.
All of this complex calculation can be moot if you pay off the debt quickly. Credit cards may have a grace period, wherein you are charged no interest if you pay off the balance in full. Usually that can range from 21-30 days. If you use a card all month long and pay it off completely before the payment due date, there is no interest charged, and you’ve essentially gotten to use the credit for free.
This is a great way to use credit cards. You get the benefits of convenience, security, and the ability to use your credit card transaction history for budgeting purposes. You also earn potential credit card rewards, and have the positive credit history associated with using a credit card responsibly*. But if you pay off the charges before the grace period, you are charged nothing extra for all of these benefits. Go one day past the grace period, and then all of those interest charges kick in and you’re charged for the whole month, calculated against your average daily balance.
By paying off your credit card in a timely fashion, you are keeping your credit utilization rate lower, improving your score. You also avoid late fees and late payments, which would lower your score.
Back to the tricky math of credit card APRs. Creditors may compound interest daily or monthly, and this will change the calculation.
What this means is, are you paying interest on the extra debt you incurred yesterday through interest? Sometimes the “real” interest rate is calculated to include the compounding, and is called the effective annual rate, or EAR. Wikipedia has an example with a credit card with a 12.99% APR that becomes 13.87% when compounding is considered.
Fixed vs. Variable APRs
If the math isn’t confusing enough, some cards will have APRs that change every month. A fixed APR is going to stay the same, unless something major happens, like you ask for a reduced rate from the creditor, or a low introductory rate expires. A variable APR is often tied to the prime rate.
The Prime Rate, usually based on the federal funds rate set by the Federal Reserve, is currently 5.25%. So a credit card might have an interest rate of 10%+ prime, giving you a rate of 15.25%. If the prime rate goes up, so does your credit card rate.
For more about these rates and other kinds of interest, see our article and infographic “What Does That Interest Rate Really Mean?”
Different APRs for different balances
To add more complexity to all of this, you might have different APRs depending on what kind of balance you incurred. You might have a purchase APR that is charged on balances incurred through regular shopping, dining, travel, etc. This is usually the credit card APR you see advertised.
Then there will be a different APR for cash advances. This is usually much higher than the purchase APR, and there will be no grace period.
Then you might have a lower APR for balance transfers, to incentivize you to move balances from other cards to a different lender.
Penalty APRs might kick in if you miss payments, go over your credit limit, or make a credit card payment that is returned for some reason. This rate is much higher than your regular APR, and can reset a low introductory rate. You’ll need to make payments on time for six months in a row to get your rate reset back down to the regular APR.
All of this is pretty complicated, and every credit card agreement is different, so your real interest charges will depend a lot on the fine print of your agreement plus your borrowing and repayment behavior.
- APR is a rough snapshot of the interest you would pay annually, but the real percentage is going to be higher due to compound interest charges.
- Interest is charged monthly, not annually, and may be compounded daily or monthly.
- Grace periods allow you to pay off credit cards and avoid interest charges altogether.
- You’ll have a different APR for different kinds of balances, like cash advances, balance transfers, and purchases.
- Interest rates might change under certain circumstances. Read the credit card agreements before applying for a card to know what might change your APR.
There is no need to carry a balance, your credit score will benefit from positive repayment habits. It’s a common credit card myth that many people believe it’s necessary to carry a balance over from one month to the next to help them build credit, that’s incorrect and could be costing you money. The best way to respond to a high APR is to pay off the card in full each month and reduce your borrowing. A certified financial coach can help you create a plan to pay off your debts and achieve financial freedom. Contact credit.org to get started.
If all the APRs you’re being offered seem sky high, talk to a credit coach about what you can do to improve your credit and qualify for better terms.