Credit Card Interest Rates: Types, When They Apply & How to Avoid Them
Complaints regarding interest rates are some of the most common gripes that people pass along to the Consumer Financial Protection Bureau, and with good reason – interest rates and the manner in which they are assessed can be quite confusing. But given the prodigious amounts of debt that we’ve racked up in recent years, it’s certainly in our best, well, interest to understand the subject a bit better.
The first thing any borrower should recognize is that there are a number of different types of interest rates that apply to different types of accounts at different times as well as a variety of different terms used to describe them. We’ll cover those topics, particularly as they relate to credit cards, in greater detail below.
Interest Rate Terminology
Part of the confusion surrounding interest rates stems from the fact that a variety of different, truly interchangeable terms are bandied about, making the topic seem far more complicated than it actually is. For example, you’ll hear the terms “rate,” “interest rate,” “APR,” “annual percentage rate,” and “finance charge” all used just to describe the costs associated with carrying a credit card balance from month to month.
With the exception of “finance charge” (which includes both fees and interest), all of those terms effectively mean the same exact thing. APR stands for Annual Percentage Rate, and is essentially the amount by which your debt will rise in cost over the course of a year in order to compensate your financial institution for lending you the money and not getting paid back immediately. In other words, interest is used to account for the difference in value between money that one has now (and could conceivably save in order to earn positive interest over time) and money obtained at a later date.
It is important to note, however, the difference between an APR from a theoretical standpoint and how it works in a practical sense. Given that credit card companies calculate interest on a daily basis and it compounds over time – meaning the interest you incur in a given month gets added to your principal balance and that total amount accrues interest the next month – your Effective Annual Rate (EAR) will typically end up being at least 10% higher than the APR listed on marketing materials and application forms, often referred to as a “nominal interest rate.”
For example, let’s say that your credit card has a 25% APR and you carry a $100 balance for a year. You’d think that the amount you owe would grow to $125 by year’s end, but it would actually rise to about $128.39, making your EAR 28.39% – a 13.56% increase over what was originally advertised.
The differential between APR and EAR isn’t uniform either. The higher your APR, the greater the disparity will be.
Types of Interest Rates
While credit cards charge a number of different types of interest rates, none of them include the penalty fees and membership fees assessed by issuers. A credit card’s interest rate structure and fee structure are entirely separate, though fees and interest are both added to your principal balance and quickly become indistinguishable. With that said, here are the different types of interest you may be charged when using a credit card.
- Purchase APR: The rate by which unpaid purchase amounts grow over time.
- Balance Transfer APR: The rate by which debt transferred from loan or line of credit to a credit card will increase until paid off in full.
- Cash APR: The interest rate that you must pay on any balance that you incur as a result of doing a cash advance at an ATM or using certain types of checks provided by your credit card company. There is no grace period for such transactions, and Cash APRs tend to be very high – usually above 22%, according to WalletHub's Credit Card Landscape Reports. Issuers also assess costly cash advance fees – also considered finance charges – that typically amount to around $11. Banks consider the use of a credit card like a debit card to be risky and perhaps emblematic of unscrupulous spending habits (paying gambling expenses, for example). As a result, consumers should strive to avoid cash advances entirely.
- Default/Penalty APR: Credit card companies automatically increase the interest rates associated with a given account to a higher default/penalty APR when the accountholder makes certain mistakes, such as missing payments or exceeding their credit limit. The default APR can only apply to existing balances if you fall at least 60 days behind on monthly minimum payments. Credit card companies are allowed to increase interest rates for future transactions at any time after an account has been active for at least a year, though they are required to provide 45 days’ notice of the change and can only apply the higher rate to transactions made 14 days after the notification is sent.
Interest Rate Changes
Interest rates are far from uniform. In fact, there are a number of reasons why they can change, some of which are related to the nature of your account management, while others are beyond your control.
One of the most common ways in which interest rates change over time is due to the difference between “introductory” and “regular” interest rates, which is broken down below.
Introductory Rate / APR: Often referred to as a “teaser rate,” an Introductory APR is the low (sometimes 0%) rate that credit card companies advertise in order to entice new customers.
- Intro APRs typically apply to purchases, balance transfers, or both. Cash APRs are not included in most cases.
- Introductory rates only remain in effect for a predetermined length of time (usually 6-18 months), known as the introductory term or period. When the introductory term concludes, higher regular rates are implemented. As a result, a credit card with a low introductory APR is only worthwhile if you can pay off all or most of your balance before regular rates take effect.
- In addition, if you are late paying your monthly bill, the credit card company might revoke your Introductory APR ahead of schedule and move you to the Default APR (which is usually above 20%).
- Regular APR: The Regular APR is another way to refer to the interest rate(s) you’re assessed for purchases, transfers, and cash advances after the introductory APR period is over. If you do not pay your monthly bill on time, the Regular APR can switch to a Default APR, which is generally much higher than what you were originally paying.
On rare occasions, you may also encounter credit cards with Tiered APRs. Such cards charge interest at different rates, depending on how much debt you incur. For example, you could pay a 16% APR on balances from $1-1,000, and a 15% APR on balances above $1000. The intent of these APRs is to encourage (or discourage) high amounts of debt.
Still, those aren’t the only reasons why credit card interest rates can change. Credit card interest rates are often tied to certain indices, which fluctuate based on changes in the economic climate. We will explain how such rates work in greater detail in the following section.
Fixed vs. Variable Interest Rates
You may have heard the terms “fixed” and “variable” used in relation to credit card interest rates or seen the “(V)” notation beside a percentage on a credit card’s terms and conditions page. Simply put, a fixed rate will not change (at least as existing balances are concerned) unless you misuse your account or a promotional period ends. Variable rates, on the other hand, are loosely tied to Federal Reserve policy and fluctuate along with changes in the overall economic climate.
But before we discuss the differences between variable and fixed rates in any more detail, it’s important that you understand the role played by the “Prime Rate.” The Prime Rate is the interest rate banks charge their most creditworthy customers, which are usually large corporations. It changes in accordance with adjustments to the Federal Funds Rate – the interest rate that applies to the money that banks lend to one another, which is held at the Federal Reserve. The Prime Rate applies uniformly to all domestic banks and changes over time.
Sometimes, the LIBOR Rate (London Interbank Offered Rate) will be used in place of the Prime Rate. The LIBOR Rate is essentially the British version of the Prime Rate and is often employed by internationally-based financial institutions in the same manner that U.S. banks use the Prime Rate. In other words, it too applies across the banks and financial institutions that use it.
With that said, let’s get back to fixed rates vs. variable rates.
- Fixed Rate / APR: Locks in your Annual Percentage Rate (APR) so that it does not fluctuate with changes to the “Prime Rate.” A Fixed APR does NOT mean that the interest rate on your credit card will never change, unless an issuer specifically notes that is the case, either in perpetuity or for a certain number years. Fixed rates can change as a result of the situations mentioned in the Interest Rate Changes section of this article.
- Variable Rate / APR: Changes over time in accordance with the Prime Rate. That means if the Prime Rate goes up 1% next month, your credit card rate will also go up by 1%. If the Prime Rate goes down, then your credit card rate will go down as well – unless the credit card company has a minimum rate. For example, a credit card company might set your credit card rate to be the minimum of “10%” OR the “Prime Rate + 8%,” which means your rate cannot dip below 10% even if the Prime Rate is as low as 1%.
These days, most credit cards have Variable Rates and it’s hard to find a credit card that has a Fixed Rate for an extended period of time.
Credit Card Interest Rates vs. Other Types of Interest Rates
One of the most confusing things about interest rates is the fact that the same terms (e.g. APR) mean different things for different types of financial products.
For instance, when APR is used in the context of credit cards, it speaks to the theoretical rate by which a balance will grow over the course of a year and does not take fees into account. With mortgages, on the other hand, certain fees (but not all fees) are factored into the APR. APRs also cannot be used for direct product comparison between loans of different lengths, as interest rates for shorter-term loans tend to be higher than those for longer-term loans since they won’t be assessed for as long.
Whenever you are evaluating financial products, you should therefore make sure to determine which costs are included in the APR, versus those you will be expected to pay in addition to that amount.
Interest, by any name, is not a borrower’s friend – especially when it is incurred unnecessarily. In other words, while taking out a loan or drawing down a line of credit and paying off the resulting balance (with interest) over time can enable us to make big-ticket purchases – such as a car, a house, or a large appliance – that would be difficult to buy in cash, leveraging debt to finance unsustainable spending habits is a money sucking recipe for disaster. Due to compounding, interest becomes more and more expensive over time, until you can no longer make the payments and you incur credit score damage. That is why budgeting for everyday expenses, taking advantage of 0% credit card offers, and using a credit card calculator to make a payoff plan for any purchase that you cannot pay off in full by the end of the month are all so important.
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