How Does Credit Card Interest Work?
Credit cards charge interest when you don’t pay off your full balance by the due date each month. When you carry, or revolve, a credit card balance from month to month, interest is charged on a daily basis, and it affects both your existing balance and any new purchases that post to your account. The interest you’re charged one day also becomes part of the balance accruing interest the next. In other words, credit card interest compounds daily. That, combined with the fact that credit cards are known for having high rates, is why credit card debt is so expensive.
But you can avoid credit card interest by paying your bill in full every month. Interest doesn’t apply to your daily balance when you do so. And most credit card companies will give you an interest-free grace period lasting roughly 25 days, from when your monthly statement gets generated to your due date. But you lose that grace period if you don’t pay in full one month, and it takes two consecutive months of full-balance payments to get it back.
That should help clarify things, at least a little bit. But credit card billing practices are complicated, and there are a lot more questions to answer. So continue reading to take a closer look at how credit card interest works, including how it’s calculated, when it starts and stops accruing, how rates are assigned, and more. You can also see how much credit card debt is costing you, and how much you could save with a better card, using WalletHub’s credit card interest calculator.
Every credit card – save for charge cards – has an annual percentage rate (APR). Technically, a credit card’s APR isn’t the same thing as its interest rate. But the two are closely related. To calculate a credit card’s interest rate, just divide the APR by 365 (days in a year). This will tell you how much interest you’ll be charged every day when you carry a balance from month to month.
For example, if your APR is 15%, you’ll be charged interest on your outstanding balance at a daily rate of 0.41%. Your outstanding balance includes any unpaid interest that was previously assessed. In other words, a credit card’s interest rate applies not only to your principal balance, but also to the interest you were assessed yesterday, the day before that, etc.
Furthermore, credit card interest applies to your average daily balance over the course of a billing period. So if you have a balance to begin the billing period and continue to make purchases throughout the month, the amount that incurs finances charges will be greater than the original balance.
Credit card companies will not charge you interest if you do not carry a balance from month to month. Most even give you a no-interest grace period of around 25 days, from the date your bill becomes available to when you need to submit payment.
But you lose that grace period if you don’t pay in full by the due date one month. Then you have what’s known as a revolving balance. You don’t have a revolving balance if you’ve paid the full amount printed on your last two bills by the due date.
It’s understandably confusing to get a credit card bill that includes interest charges after bringing your account balance to zero. In some cases, it might end up being a mistake on the credit card company’s part. But it’s most often a simple case of misunderstanding the credit card billing process.
So let’s try to set the record straight, starting with a practical example.
Say you didn’t pay your last monthly bill in full and owe $500 when your next month’s credit card statement becomes available on June 1. While you may have until June 30 to submit a payment before it’s considered late, interest will be assessed based on the average daily balance in the interim. That means the amount you owe will increase with each passing day.
So even if you pay off the full $500 balance by the due date (June 30 in this example), you’ll still owe money for the interest charged daily since June 1. As a result, when your new bill becomes available on July 1, your balance will be equal to the interest you racked up the previous month. If you do not pay this amount, you will incur interest on interest and will continue to do so until you have paid two consecutive bills in full, regaining your grace period.
What can you take away from this example?
- If you begin a billing period with a revolving balance, interest will accrue on a daily basis.
- Paying off your original balance won’t bring your total account balance to zero. You will be responsible for the interest that accrued from the time your bill was made available to when your payment arrived.
The perhaps confusing distinction between your original balance and the finance charges that accrue on top of it underscores the importance of carefully reviewing your monthly credit card statements. Doing so will enable you to spot unanticipated charges as well as raise questions about potential mistakes.
The interest rate you’ll receive when you open a new credit card account is a product of your credit score and disposable income. Credit cards for people with excellent credit tend to have far lower interest rates, on average, than those geared toward people with limited credit, for example.
In addition to dictating which tier of offers you qualify for, your overall credit standing will impact the particular rate you’ll get from a card that advertises a range of possible APRs. For instance, an application may list an APR of 10.99% to 20.99%. The strongest applicants will get rates on the low end of that spectrum, and vice versa.
It’s also important to note that credit card companies are able to raise and lower interest rates on existing accounts under certain circumstances. They can increase interest rates on new transactions at any time, as long as they give you at least 45 days’ notice of the change taking effect. They can also freely raise rates on existing business credit card balances, though you must be at least 60 days delinquent for such an action to be taken with a general-consumer credit card. Interest rate decreases can occur at any time. They’re typically the result of a cardholder improving his or her credit score or entering into a debt management agreement.
Finally, most credit card interest rates are tied to some type of economic index, such as the Prime Rate. That’s what “(V)” next to an APR means. Changes to this rate can result in interest rates rising or falling across the board.
Paying off what you charge to a credit card every month is the best way to avoid interest, obviously. But it’s not the only one. There are a few other things you can do to ensure that finance charges won’t show up on your account. We’ll explain them below.
- Pay as soon as possible: Interest gets assessed daily, so waiting for your due date when revolving a balance will result in 30 days of new finance charges that you’re responsible for. So if you want to pay as little as possible in interest when carrying a balance, pay your bill the same day it becomes available.
- Use a 0% credit card: Zero percent credit cards allow you to avoid interest on purchases or a balance transfer for a certain number of months after opening an account. You just have to make minimum monthly payments to keep your 0% intro APR. And you should pay off most, if not all, of what you owe before your card’s high regular APR takes effect.In most cases, regular interest rates will apply to whatever balance remains at the end of the 0% intro period. But when stores offer 0% financing, it often includes something called “deferred interest.” That means if you fail to pay down your full balance by the end of the 0% term, regular rates will retroactively apply to your entire original purchase amount. Avoid deferred interest payment plans at all costs.
- Use a credit card calculator: If you want to save money with a 0% credit card, you need a concrete plan for paying off your balance. WalletHub’s credit card calculator can help you figure out how much to pay each month and which card offers the best collection of rates and fees for your needs.
- Use the Island Approach: Separating your ongoing purchases from your revolving debt will ensure that interest rates apply to the lowest possible amount. Given that you should be able to pay for everyday expenses like gas and groceries in full every month, isolating such expenses on one credit card will prevent the average daily balance on your card designated for debt from being unnecessarily high. This, in turn, will lower your overall interest charges.
- Ask for a Lower Limit: If you continually spend more with a credit card than you can afford to pay back, you might want to consider asking the issuer for a lower limit to remove temptation.
Understanding how credit card companies calculate interest can be helpful. But it’s not required to know that debt can be bad for your finances. Interest is extremely expensive, for one thing. And it can quickly become unmanageable, causing you to miss payments and hurt your credit score.
In other words, keeping a budget, regularly reviewing your spending habits, and avoiding unnecessary debt are essential to responsible money management. And you’ll thank yourself later if you're successful.
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