How does credit card interest work? Understanding APR, calculations, and tips to save

What is credit card interest?

When people say “credit card interest,” they’re usually referring to annual percentage rate (APR), which includes additional fees and costs on top of the base yearly interest rate. Lenders typically divide this by 365 to find the daily interest rate they’ll apply to your balance.

Most credit card interest compounds each day, based on the average balance you hold over a billing period. However, the lender will typically calculate all of this at the end of a billing cycle and give you a single monthly charge.

If you carry a balance from month to month, the interest charges on the credit card can keep adding up (even if you don't make any new purchases). This can potentially make it more challenging to pay off debt over time. That's why it's important to understand a credit issuer's terms and conditions before applying for a credit card and when using a credit card.

How lenders determine interest rate

The APR includes credit card interest rates and additional fees, and will vary depending on lenders, card types, and your credit details. These are some of the considerations that go into APRs:

• Creditworthiness: Someone with a high credit score and a good credit history may receive a lower APR because they don't present a great risk to the lender.
• Debt-to-income ratio (DTI): This is a calculation of someone's gross monthly income divided by their debt payments. A high DTI may yield a high APR, as it shows the borrower has many debts to pay off.
• Fees: The APR may include other fees set by the issuer for the credit account.
• Federal Reserve benchmark: Many issuers may base their APRs on the prime rate set by the Federal Reserve.
• Transaction type: Different transactions may have different interest rates. For example, cash advances typically have higher interest rates than purchases do, and balance transfers may have promotional interest rates that eventually increase after a certain period.

What are the different types of credit card interest?

Credit cards often have several types of interest rates, or APR, for different types of transactions. There’s usually a variable or fixed base rate, and then special interest rates for certain transaction types:

• Fixed-rate APR: A fixed APR remains the same for the entire term of a loan.
• Variable-rate APR: An interest rate that fluctuates along with an index. The actual rate may change month to month.
• Introductory APR: A special rate offered to new account holders. These are usually very low or zero interest with a temporary term.
• Penalty APR: An APR applied to a balance if the user violates the terms of an agreement. For example, if a user has a balance on a 6-month 0% APR promotion, but doesn’t pay off the whole balance by the 6th month, a penalty APR could be applied to the entire balance.
• Special APR: Some credit card issuers apply unique APR rates to transactions, such as cash advances or balance transfers.

Credit cards may have multiple interest rates on different balances running concurrently, depending on promotions and other circumstances. Be sure to thoroughly read the terms of any credit you take out so that you understand the rates.

It's also important to note that the issuer might advertise a representative APR. This is not a guarantee, and you’ll likely receive a different APR offer if you’re approved for the credit card. This is known as a personal APR, based on your credit details, and is the actual APR that will apply to your credit card account.

How to calculate credit card interest

You can approximate monthly interest using your credit card’s APR. Your APR is the annual interest rate, so you find the monthly interest by dividing your APR by 12.

Example: With an 18% APR, your monthly interest will be approximately 1.5%.

However, this will only give you a rough estimate. You can calculate a closer approximation of monthly credit card interest by multiplying the average daily balance on your statement by the daily periodic rate and the number of days in the billing cycle.

To demonstrate how to effectively calculate interest, let’s calculate a scenario with real numbers:

• Your APR is 20%
• Your statement balance is $2,500
• You spent $500 on day 1 of your statement cycle.
• You spent another $2,000 on day 11 of your statement cycle.
• Your statement cycle is 31 days.

In this case, you would pay approximately $31.62 in interest.

However, the true interest calculations can be more complicated due to the effect of daily compound interest. An accurate charge will appear on your credit card statement.

Here’s a step-by-step breakdown of how the formula works:

1. Find the days in the cycle

In credit card terms, “days in the cycle” refers to the length of the credit card billing cycle.

This is the period during which cardholders can make purchases with their credit card. At the end of the cycle, the issuer can send a statement that outlines the balance, minimum payment, and due date.

The number of days in the cycle can vary depending on the credit card issuer, but it's typically around 30 days. During this time, any unpaid balance on a credit card can start accruing interest charges.

In our example, there are 31 days in the cycle.

2. Find the daily periodic rate

The daily periodic rate is calculated by dividing your APR by 365 (or 360 for some lenders; check your terms and conditions to see which applies to you.

For example, if your APR is 20%, this calculation would be:

.20 ÷ 365 = 0.00055, or .55%

3. Find the average daily balance

Most commonly, credit card institutions calculate an average balance across all the days in a billing cycle and then use that number to determine interest.

Find the average daily balance by adding each day’s balance and then dividing the total by the number of days in the billing cycle.

For example, you have a balance of $500 for 10 days, and then make a large purchase that increases the balance to $2,500, which you hold for 21 days.

Add the daily balances together:

• $500 over ten days adds up to $5,000
• $2,500 over 21 days adds up to $52,500
• The total balance is $57,500

Divide the total balance by the number of days (31):

57,500 ÷ 31 = 1,854.83

The average daily balance is $1,854.83

4. Multiply DPR with ADB and days in billing cycle

Now that you know each of the numbers in the formula, you can multiply them together.

Remember, the formula is DPR * billing cycle days * ADB:

0.00055 * 31 * 1,854.83 = 31.62

So the interest charge is $31.62.

When do credit cards charge interest?

You get charged interest on a credit card when you don’t pay your balance in full each month. When you receive your bill, you have a few options for paying the balance:

• Pay the required minimum balance set by the credit card issuer. This is typically at least 1% of the balance.
• Pay a partial balance if the issuer allows.
• Pay off the total balance in full.

If they don't pay their bill in full, the credit card issuer can charge interest on the unpaid balance, even if they make the required minimum payments on their credit card.

You may also encounter residual interest on credit cards, which is the interest you owe on balances after you pay them down to $0. If you have an outstanding balance from a previous month, it earns interest every day, so you’ll still be charged interest at the end of the next month even if you pay off the balance completely.

How to avoid paying interest on a credit card

Even though interest compounds daily, you can avoid it by paying off your balances in the same month.

When you receive a credit card statement, you may have a grace period during which you won't be charged interest as long as you pay off the entire balance. If you partially pay the balance, you’ll pay interest on what remains.

Spending within your means is the best way to avoid taking on debt. By setting spending limits, you can ensure that you don’t overspend.

Here are some specific credit card strategies to limit how much interest you pay.

1. Pay bills in full

The simplest way to avoid interest charges on purchases is to pay your balances in full each month.

Every month, your credit card issuer sends you a statement. Most credit cards give you a grace period between when they send you the statement and the bill’s due date. If you pay during that time, you’ll avoid interest.

2. Pay off debt as soon as possible

If you can’t pay the full balance, try to make more than the minimum payment. You want to reduce the borrowed amount as quickly as possible because that reduces the total amount of interest over time.

3. Put large purchases on 0% APR plans

If you plan large purchases carefully, you can avoid paying interest. Many credit cards offer 0% APR promotions, especially as introductory offers. As long as you pay the whole balance before the promotion ends, you can finance a purchase over time without interest.

However, make sure that you keep up with the payments. If you miss payments or don’t pay off the balance on time, the institution may charge a penalty interest rate for the entire balance.

How to pay down credit card debt

If you’re struggling to pay down credit card debt, it’s helpful to build a plan and focus. The faster you get rid of the debt, the better off you’ll be, and it’s never too late to start.

Creating a budget like the 60/30/10 budget can help you visualize your finances and stick to your goals. Here are a few tips:

• Pay more than the minimum amount: Pick one debt balance and pay more than the minimum amount. Focusing on one line of credit at a time gives your money the most impact.
• Debt avalanche method: Choose the debt with the highest interest rate to focus on first. This reduces the amount of interest you pay the fastest.
• Debt snowball method: Choose the smallest debt and pay it off as fast as possible, then take that monthly payment and apply it to the next largest debt. This method can free up more money more quickly.
• Balance transfer: Some credit cards offer lower interest rates for a limited time if you open an account by transferring an existing balance to it. The advantage for the company is that they acquire the debt and your interest payments. The advantage for you is potentially a lower interest rate.

Potential risks of using a credit card

While some people benefit from getting a credit card, they also bring potential risks, notably related to credit interest charges. Interest charges can add up and potentially cause difficulty in paying off credit balances.

Some associated risks when using credit cards can be:

• Debt accumulation: Having multiple accounts means you can acquire multiple sources of debt. This can become unmanageable quickly.
• High interest rates: Credit cards can have high interest rates, meaning you pay a lot to borrow money.
• Changes in terms and conditions: Pay attention to communications from your credit card company because interest rates and other terms can change.
• High long-term cost: Due to fees and interest rates, holding long-term debt on credit cards can cost a lot of money over a long time. It’s possible
• Fraud associated with data breaches: When a website stores credit card data, your information becomes vulnerable to data breaches. Always consider the security tradeoff of convenience features, such as having a website remember credit card information. Consider using a payment app like PayPal that encrypts payment information to avoid putting information directly into website systems.