How Does Credit Card Interest Work?
- June 10, 2017
- Posted by: Jeff Gitlen
- Category: Credit Cards
Have you ever had to ask someone how credit card interest works?
Sadly, most people today have no idea.
Instead, they use their card and pay their bill, often the minimum amount due, without understanding the ramifications of those seemingly innocent actions.
If you have a credit card, it is important to learn about credit card interest so you don't end up drowning in debt because you simply didn't know how it worked.
How Interest Rates Work in General
Almost all credit cards, loans, or other forms of credit will be issued with an interest rate. Interest is what the lender charges to lend to you and is how they make money. Interest is charged as a percentage of the total loan balance.
So, for example, if your interest rate is 10 percent and your balance is $10,000, you would end up paying $1,000 in interest.
Annual Percentage Rate (APR) & Daily Periodic Rate (DPR)
For credit cards specifically, you will be given an Annual Percentage Rate, or APR. The APR is the amount of interest for the total balance of your credit card paid annually.
The better your credit and the more you make credit card payments on time, the lower your interest rate. For the amount of interest that you pay throughout your monthly statement period, credit card companies use the APR for calculations.
Since not all months have the same number of days, card issuers use a Daily Periodic Rate. For determining the DPR, the card issuer divides the APR by 365 (days in a year).
You will be charged your DPR every day if you carry a balance after your grace period. In other words, you will only be charged a DPR if you don't pay off your full credit card balance each month.
Let's look at an example:
Say you have a $1,000 credit card balance that is no longer in its grace period and your APR is 20%. Given the APR of 20%, your DPR would be 0.0548%.
Your first interest charge would be $0.55 (0.0548% * $1,000) and your new balance would be $1,000.55. The next interest charge (assuming you don't make any payments within the next day) would be based off of your new balance of $1,000.55.
This is why credit card interest can be so damaging. It compounds every day and each interest charge will continue to grow until you make a payment.
How Credit Card Interest Rates are Determined
Several factors determine the amount of interest you pay on your credit card, which includes your credit score. The majority of variable interest rates are subject to change in coordination with the Prime Rate, which is 3 percentage points above the federal funds rate - set by the Federal Reserve Bank. Also, a credit card issuer can charge you separate interest, along with additional fees on your balances and your cash advance balance.
To save on interest, pay the full balance on your card monthly. Although you have a grace period, which is usually 21 days, make sure you never pay beyond that date. On-time payments coupled with good credit will save you a significant amount of money in interest.
Allowable High and Low Rates
Due to fierce competition among credit card issuers, many offer credit cards to new cardholders with 0 percent APR, but only for a specified period. This means if you make purchases with your card during that introductory period, you pay no interest. However, you have to be careful. Often, once the introductory period ends, the APR skyrockets.
There is no cap on the maximum allowable interest rate charged. This is why some national banks charge as much as 79.9 percent, but only if the issuer discloses those terms as required under the federal Truth in Lending Act. Most credit card issuers cap the interest rate at 29.99 percent.
How Late Payments Affect Interest Rate
Making on-time payments on your credit card is essential. If you pay late, several things can happen. If you make your payment past the grace period, the issuer can charge you a late fee. If you continually miss making your payments on time, the issuer will likely add on more late fees. Along with that, late payments will negatively impact your credit score, at which time you can expect to see a hike in the interest rate charged on your credit card.
Your credit score also plays a significant role in how much interest you pay. The higher your credit score, the lower the interest rate. When you maintain good credit, you are not much of a risk to the issuer. However, with repeated late payments and a poor credit score, your rates will increase since the issuer now deems you a risk.
Interest Rate Regulations
According to the Credit Card Accountability, Responsibility, and Disclosure Act of 2006 (CARD Act), certain restrictions apply to account fees. Therefore, credit card issuers cannot charge more than $25 in penalty fees for a first offense or more than $35 for repeated offenses within six billing cycles.
Unfortunately, there are no regulations or caps for credit card interest. The reason some issuers charge outrageous interest is that state usury limits for interest on credit cards are considered irrelevant for banks which was the result of a decision passed down by the Supreme Court and federal laws.
The good news is that under the CARD Act, credit card issuers must review interest increases after Jan. 1, 2009. Although a reduction in interest is not mandated, the issuer is required to lower the interest rate if appropriate. Also, if the cardholder makes six consecutive payments on-time after an interest rate hike, the issuer must stop the increase.
Negotiating Credit Card Interest
As long as you have good credit, pay your credit card bill on time, and have been a cardholder with a particular bank or company over an extended period, you should be able to request a reduction in your interest rate. As a favorable customer, there is a good chance of getting your interest rate lowered.