Is it time to celebrate? Did you just get your first credit card and now you’re wondering how the interest will work? Or have you been using credit cards for a while and starting to wonder why your balance never seems to go down even though you’re making your minimum monthly payment on time every time? Credit cards can come chocked full of different fees and terms, and even interest rates. Interest rates can be fixed or variable, or even temporarily fixed for a short amount of time before switching to a variable. They can change on what seems like a drop of a dime, or depending on your spending, and payment behavior.
Credit cards can be really confusing, especially if you’re new to the line of credit game. The majority of credit card companies are sure to put all of the details explaining your card in detail deep in the fine print. For any card you have currently or considering applying for, it’s best to make sure you know the terms the card company is offering inside and out. But if you can’t do that, or just don’t have the time, there are a few minimal pieces of credit card knowledge you should stock your brain with.
The most important of these pieces of knowledge, perhaps, is knowing how credit card interest works in terms of billing cycles and compounding methods. Most people have credit cards, and at least half of credit card owners carry a balance which is subject to interest. Credit card interest is spoken of in terms of APR (Annual Percentage Rate). The interest rate can vary from card to card and from time to time. And they definitely vary from person to person based on each person’s credit score.
APRs are identified in terms of a year. But your daily interest rate is a different number. To find out what you’re paying each day in terms of interest, simply divide the APR by 365 days. So if your card carries a 14.95% APR, divide 14.95 by 365 and you see that you are paying 0.0409589% interest on a daily basis. So if you carry a balance on one day of $495, the interest the credit card company will charge you for that day is $495 x 0.0409589% (or 0.000409589), which is $00.20.
The next day, provided you haven’t made any new purchases or payments, your balance will be $495.20. At the end of the day, interest is calculated again but, this time it’s calculated against the new balance. So, $495.20 is multiplied by 0.0409589% or 0.000409589. Interest for this day comes to 20 more cents. Your total balance for this day is now $495.40. The following day, 20 more cents is added to bring your balance up to $495.60.
What if you make a $2000 purchase on your card, bringing the balance up to $2495.60? What would be the interest at the end of the day you made this big purchase? The same rules apply. Interest is calculated daily regardless of the balance. The credit card will multiply your balance of $2495.60 by 0.000409589 which is $1.02.
Your balance at the end of the day will be $2496.62. If you make no new charges and you have, let’s say, 10 days left in your billing cycle then, you’ll be charged $10.22 in interest more before your next payment is due, bringing your total balance to 2506.84. You’ve made $2495.00 worth of purchases and generated $11.84 in interest for the credit card company over a 14-day period.
Variability In Interest Rate
Each card is unique. Some may come with very straightforward APRs, while others may offer one APR for purchases and another for balance transfers and cash advances.
Many card companies offer introductory APRs for terms of six months, a year, or other predetermined time periods. Then the APR adjusts after that period is over. If you do apply for a card of this nature, just make sure you know what the APR is after the introductory term expires.
Some credit card companies do offer grace periods for a certain amount of time for each billing cycle. If you pay off your balance in its entirety each billing cycle before the grace period expires (usually by the payment due date), the credit card company will not charge you interest for that billing period. If you don’t pay your balance off in full, then the interest charges will appear during the next billing cycle. Not all credit card companies offer grace periods, so make sure to read the fine print of any credit card offer you receive.
Credit cards often come in the form of variable rates. These variable rates fluctuate at a certain number of percentage points above prime. The prime rate is based on the federal funds rate, plus three additional points. Because the federal funds rate can fluctuate, your variable rate will fluctuate too. So just make sure if you are considering a card with a variable rate, the terms of the rate are something you are prepared to deal with financially.
The Minimum Payment
Credit card companies offer very low minimum payments for a reason. The less you pay off each month the more interest rate a credit card carrier can let accumulate in your account. While it may be saving your budget month to month to pay just the minimum balance, in the long run, you end up paying much more when you finally do end up paying off what you owe.
Also, your credit rating is done no favors by only paying the minimum each month. As your debt to credit ratio tightens, your credit score will begin to go down. That’s because a significant portion of your credit rating is based on the comparison of how much debt you owe to how much credit you have available. Paying off your balance is your surest bet to maintaining a high credit rating and paying minimal interest month to month.