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Credit Cards

How Does Credit Card Interest Work?

Updated Sep 21, 2021   |   8 mins read

Americans love using credit cards. In fact, the Consumer Financial Protection Bureau reported that Americans had more than $4 trillion in total credit card lines in mid-2017, and around 169 million consumers had at least one credit card. Credit card use has actually been trending upward, too. According to the Federal Reserve, consumer credit increased at a seasonally adjusted rate of 4.5% in February 2019.

Although credit card debt carries a negative connotation for obvious reasons, using credit cards can help you improve your credit score by developing a positive payment history, which comes in handy when it’s time to buy a home or take on other types of consumer debt. Some cards even help you earn valuable cash back or rewards you can use on travel, gift cards, and more.

Unfortunately, one aspect of credit cards many Americans haven’t fully wrapped their heads around is the prohibitively high interest rates associated with most cards. Interest charges can be crippling and can destroy your ability to accomplish other financial goals, so it’s imperative to your financial well-being that you fully understand how credit card interest works.

This guide will help you understand more about your card’s interest rate so you can make informed choices about using your cards responsibly.

In this guide:

What Does APR Mean?

APR stands for annual percentage rate. It’s the rate you pay for credit — including interest and fees — stated as a yearly rate. APR tells you exactly how much it costs to borrow money with a particular credit card or loan. It can be a more accurate measure than the interest rate alone of how much credit costs since it takes both interest and fees (e.g. annual fees) into account. 

>> Read More: APR vs. interest rate

What Is a Purchase Interest Charge?

When you get a credit card, one of the most important rates to understand is your purchase APR or purchase interest charge. It can be confusing to cardholders because you don’t necessarily pay your purchase APR every time you buy something. You only pay a purchase interest charge if you don’t pay off your purchase in full by the end of your billing cycle.

However, the purchase APR may not be the only rate that applies to your credit card transactions. You may have a different APR for balance transfers or for cash advances.

Balance transfers occur when you transfer debt from another card, usually to take advantage of a 0% intro APR that lets you pay off the balance without incurring additional interest. Cash advance rates, on the other hand, apply when you access cash from your credit card through an ATM machine or if you use a cash advance check. The APR on cash advances is usually higher than your purchase APR.

How is Credit Card Interest Calculated?

One of the most important things to know is that just because your APR is expressed as an annual percentage rate doesn’t mean you’re only charged interest once per year. In fact, you’re charged interest every day you have an outstanding balance on your card if you don’t make your monthly payment in full by your due date.

With most credit cards, interest compounds on a daily basis. This means if you owe $100 and are charged $.01 in interest on Monday, then on Tuesday you owe $100.01 and you are charged interest on that balance instead of the $100 balance. Because interest compounds daily, you end up paying interest on interest charges, which makes it harder to pay off your card.

Say, for example, you have a $1,000 balance on a credit card with 14% APR and interest compounds daily. On your first day owing this balance, you’ll incur about $0.38 in interest (14% of $1,000 divided by 365); over a month, you’ll incur about $11.73 in interest charges. Over the course of the year, if your $1,000 balance remains unchanged, you’d be charged around $154.72 in interest.

These daily interest costs can become very expensive very quickly, especially if you’re making only minimum payments on your cards. Carrying a credit card balance can also hurt you your credit score. When your credit utilization ratio, or the amount of available credit you’re using, is too high, your credit score will be lower as a result. This could mean higher interest rates on other types of debt such as mortgages, auto loans, and personal loans.

What are Typical Credit Card Interest Rates?

Your credit card interest rate isn’t necessarily the same from one card to another. Both your personal credit history and the credit card you choose will affect the APR you’re assigned.

If you have a limited credit history or a record of missed payments, you’ll likely be approved for a bad credit credit card with a higher interest rate. If your credit report reflects a history of on-time payments and a low credit utilization rate, you have a better chance of qualifying for one of the best credit cards with better perks and lower rates.

You should shop around when it comes to credit cards, as some offer very competitive rates — especially to well-qualified borrowers.

How Can I Avoid Paying Credit Card Interest?

Although credit card interest can be very expensive, there’s a simple way to use your cards regularly — and reap all of the rewards of doing so — without ever paying a dime in interest. You just need to pay off your credit card statement in full by the due date. Interest applies only to balances left unpaid after the due date, which varies by card but is typically around 21 to 25 days after the billing cycle closes and the statement is generated.

Your credit card company likely only requires you to remit a minimum payment that’s far less than the total balance you owe. Making only minimum payments, of course, will significantly increase your interest charges over time.

The good news is you don’t need to pay your entire credit card bill to avoid interest charges. You only have to pay the balance that applied when your billing cycle closed, which will be reflected on your billing statement. Interest on any new purchases won’t come into play until your next monthly statement.

How Can I Lower My Credit Card Interest Rate?

If you want to lower your credit card interest rate, you have a few options. One is to ask your credit card issuer to reduce your rate. They may be willing if you’ve been a good customer. Another option is to do a balance transfer to a credit card with better rates, preferably a 0% introductory APR that applies for a certain period of time.

Paying off your debt in a timely manner and improving your credit score can also help you qualify for cards with lower interest rates.

How Can I Pay off My Credit Card Debt Faster?

Since you don’t want to pay a fortune in interest, it’s a good idea to look for ways to pay off your credit card debt early.

You can do this by making a budget that prioritizes debt repayment over unnecessary spending and paying more than the minimum amount due. Make it a goal to pay off as much of your debt as you can each month before you spend your paycheck on clothes, restaurants, or other purchases you can go without.

A balance transfer to reduce your interest rate — or consolidating debt with a low-interest personal loan — can also help you speed up repayment, as less of your money will be spent on interest and more will go toward paying down the principal.

Bottom Line

Credit card interest can be very expensive. You should shop around for a card with the lowest purchase interest rate you can find if you plan to carry a balance. Or, ideally, pay down your credit cards ASAP and then pay off your balance in full every month so you can benefit from having a credit card without having to pay any interest at all.

>> Read More: How do credit cards work?