Penalty / Default APR Explanation & Tips
The Penalty (or Default) APR is the interest rate that is applied to either a portion or the entirety of your balance once your credit card is in default.
The rules for when the Penalty APR applies are different for general consumer credit cards and small business credit cards, as the latter were excluded from the Credit CARD Act of 2010. Below you will find separate explanations of how the Penalty APR works for both types of credit cards.
Consumer Credit Cards
Credit card companies can increase your interest rate for future transactions – not your existing balance – for any reason (including missing one payment or going over your credit limit) once your account has been open for at least 12 months. The only interest rate repricing that can occur during the first year is if an introductory rate cedes to a regular APR. This is designed to prevent bait-and-switch tactics by credit card companies.
If the credit card company changes the interest rate that applies to future transactions, the CARD Act requires it to send you a notice specifying the reason for the rate increase 45 days in advance, and the rate increase can only apply to purchases made 14 days after the notice was sent. It sounds complicated, but these rules are actually an improvement over the pre-CARD Act environment.
The only time the penalty (or default) APR can be applied to your entire balance (existing debts and future transactions) is if you become 60 days delinquent in making a minimum payment.
Fortunately, the new credit card law also provides specific guidelines for how to get back to the regular APR for your existing balance after the Penalty APR has been triggered. The law states that once the rate is increased on an existing balance because you were 60 days delinquent, the credit card company must move you back down to your non-penalty APR once you have made the next six consecutive payments on-time.
Finally, the Credit CARD Act also created provisions that require credit card companies to re-evaluate a rate increase every 6 months and, if appropriate, it must reduce your rate within 45 days after completing the evaluation.
You can protect yourself from the cost and credit score damage associated with missed payments by arranging for your minimum payment to be automatically deducted from a checking account each month. This arrangement is called ACH or Automatic Bill Pay.
Additionally, if you receive notice that the Penalty APR will apply to future transactions in 45 days and you feel the rate is too high (most likely it will be), we recommend that you stop using that card to make any new purchases. This way you can pay down your existing balance at your own pace and at your regular APR, without worrying about being charged an unmanageable Penalty APR for new purchases.
Business Credit Cards
Given that small business credit cards are not covered by the CARD Act, they are not protected by the rule that a cardholder must be at least 60 days delinquent for the penalty APR to apply to existing balances. As a result, the Penalty (or Default) APR for small business credit cards is the interest rate applied to your entire balance once your credit card is in default. The triggers for the Penalty APR vary for different credit cards, but generally include missing one payment, going over your credit limit, or making a payment that is returned.
It is very important to protect yourself from the Penalty APR, particularly if you carry a large balance on your credit card (as many small business owners do). Penalty APRs are usually above 20%, after all. That means if you have a credit card with a regular APR of 10% and a balance of $5,000, for example, and you miss a payment triggering a 20% penalty APR, it will cost you an additional $500 each year!
Some credit cards also have a different Penalty APR for cash advances, which is referred to as the ‘Cash Penalty APR’ and is usually higher than the Penalty APR applied to purchases and balance transfers.
Given the exclusion of small business credit cards from the Credit CARD Act, such cards should not be used for business funding purposes. Rather, they should only be used for everyday purchases that you will be able to pay off in full each month. And a https://wallethub.com/credit-cards/0-apr/>0% consumer credit card can be used to handle company financing.
There are a few reasons why this is an effective strategy. For starters, you’re not opening yourself up to any added liability by using a consumer card. Small business credit cards, contrary to what some people think, do not shield you from personal liability for company debts. In fact, all of the major credit card issuers hold small business owners personally liable for unpaid business card balances. Consumer cards also tend to offer more attractive 0% deals, and by using such a card for funding, you’ll be picking up some valuable CARD Act coverage.
On the other hand, it’s wise to use a small business rewards card for everyday purchases because such cards offer uniquely valuable rewards in popular business spending categories, such as office supplies and telecommunications services. They also typically provide sophisticated expense tracking tools.
Using one type of card for funding and another for everyday spending is also an example of a very useful credit card strategy known as the Island Approach. By segmenting your financial needs onto different credit cards, as if they are on separate islands, you give yourself the opportunity to get the best possible terms for each type of transaction you’ll be making. Keeping everyday transactions to their own account will also enable you to keep spending under control because the presence of finance charges will alert you to the need to cut back.
Finally, make sure you are aware of what will activate the Penalty APR on each of your credit cards. Call the customer service telephone number for each of your cards and speak with an agent to make sure you understand the Penalty APR trigger for each of your credit cards. You can also read the terms and conditions sheet that you received when you applied for your credit card. These terms are subject to change, however, so make sure you have the most recent information.
Image: Brian A Jackson/Shutterstock
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