Receiving a credit card application can be exciting — especially if you’ve been preapproved for a card.
Credit cards can allow you to make purchases immediately, even if you don’t actually have the money in your bank account. But before you run full steam ahead into applying for any credit card, it’s absolutely critical that you understand credit card interest, how it is calculated, and how you can avoid having to pay it.
Banks and other lenders providing you the opportunity to use borrowed funds might initially sound like a great deal! But the reality is that these entities aren’t giving you anything for free — and if you’re not careful, you can end up paying quite a bit for the “opportunity” to use their money.
How Borrowing Money Really Works
Being extended credit through a credit card is essentially a process of borrowing money. In this case, the credit gives you money all at once that may not otherwise be available to you, especially if you’re making a high-dollar purchase (like a new computer or big screen TV).
Credit Comes at a Price
But credit — particularly credit that’s provided to you through credit cards — can also come at a very high price.
Hot Tip: While many people don’t think of it this way, the reality is that every time you use a credit card, you’re getting a loan from the lender or creditor that issues that card. In essence, you are promising to pay back the amount you charged on the card.
Let’s take a look at a basic example of borrowing money. Here, we’ll say that you borrowed $1,000 for 2 years with a simple interest rate of 5%. In this case, you will pay back a total of $1,100.
This is because your 5% interest rate equates to $50 per year ($1,000 x .05 = $50). You paid interest for 2 full years ($50 x 2 years = $100), plus you repaid the $1,000 in principal.
If you made these loan payments on a monthly basis, the amount of your payment would have been $45.83 ($1,100 divided by 24 monthly payments).
While this may look cut and dry, not all borrowing situations are the same — nor do all lenders and creditors charge a simple rate of interest on borrowed funds.
Though most credit cards do have a set rate of interest, if you don’t pay back the entire balance in full by the payment due date, the creditor that issued the card will not only charge you interest on the remainder of your principal balance but also on prior months’ interest charges.
That can really add up!
The Impact of Different Interest Rates
Before you take on any type of debt (especially credit card debt), it’s important that you shop around to secure the best interest rate. One reason for this is because a difference of even just half a percent could be significant in the total amount of money that you end up paying back.
As an example, take a look at 2 identical home loans, where the only difference is the interest rate. In each case, the individual is borrowing $100,000 for 30 years.
With Loan #1, the interest rate is 4.5%, while Loan #2 has an interest rate of 5%.
|Monthly Payment||Total Repayment Amount|
|Loan #1||$506.69||$506.69 x 360 months = $182,406.71|
|Loan #2||$536.82||$536.82 x 360 months = $193,255.78|
In this case, the difference in the cost of total repayment between these 2 loans was nearly $11,000, based just on the different interest rate that was charged!
Deferred vs. Standard Interest
In addition to knowing the interest rate you’re paying — and how much it can add up if you don’t pay off your credit card balance each month — it is important to know whether you’re paying standard or deferred interest because this can make a big difference.
As an example, many retailers advertise an “introductory” interest rate of 0% in order to entice consumers to apply for their proprietary credit cards. But just because you may not be charged interest for the first few months doesn’t mean that you won’t be charged interest at all.
The terms “no interest for 6 months” and “no interest if paid in full within 6 months” are 2 very different things. The latter is what’s called deferred interest.
With deferred interest, you could even end up paying more down the road if you keep a running balance on the card.
Here’s why: Let’s say that you apply for a Macy’s credit card, where the interest rate is normally 26.24%. When you initially apply for the card, though, the retailer offers you 0% interest for a specified promotional period if your balance is paid in full within that time.
This might sound like a great deal — and it could be, provided that you don’t carry a balance on the card and pay it off in full within the promotional period. However, if you don’t, interest charges will be imposed on the starting balance at the APR for regular purchases retroactively from the date of purchase.
That’s because, with this type of financing, the interest on the purchases you make with the card technically isn’t waived. Rather, it is deferred unless you pay your balance in full. Essentially, it is continuing to rack up — even during your promotional 0% interest rate period.
In cases like this, it can definitely be to your advantage to pay off the entire balance before the promotional period ends. Otherwise, you will be charged interest retroactively (in this example, at a rate of 26.24%) starting from the initial purchase date.
Another thing to consider? Some people think by paying only their minimum payments, they’ll achieve a zero balance by the end of the promotional period. Sadly, oftentimes this isn’t the case so individuals who think they’ve been acting as a responsible cardholder get a big surprise when deferred interest is applied.
Bottom Line: Know your terms when it comes to special financing! The difference between “no interest for 6 months” and “no interest if paid in full within 6 months” is a big one!
Interest Rate and APR Are Not the Same — and Why It Matters
While you might be familiar with how interest rates work in borrowing situations, the APR (or Annual Percentage Rate) can often seem confusing. In its most basic sense, an interest rate is the “price” that is paid for borrowing money.
When it comes to credit cards, though, interest rates are often stated as annual rates. This is referred to as the Annual Percentage Rate (APR).
The APR takes into account the total cost of borrowing money from the credit card issuer, which can encompass the interest rate as well as other fees that you incur.
The Dangers of Borrowing Too Much
Today, it’s rare for people to carry around a great deal of cash in their pockets. Instead, using credit can make transactions of nearly any size much quicker and more convenient. Unfortunately, though, borrowing too much can end up being hazardous to your financial health.
Because credit cards will often have a nice-sized limit, it can be much easier to purchase on impulse as opposed to having a real need for the item or service.
Bottom Line: Having too much debt can also make it much more difficult to pay off your balance in full each month, which can end up costing you a lot.
Are You Becoming Trapped by Credit Card Debt?
When it comes to borrowing for purchases like a car or a home, credit cards work a bit differently than these types of loans. But, rather than knowing (in most cases) what your payment will be each month, the amount you owe on a credit card balance can continue to grow — even if you don’t make any additional purchases.
How Credit Card Interest Is Calculated
Let’s take a look at how credit card interest is determined, and how it can start to snowball out of control if you don’t pay off the balance each month.
In this example, let’s say you purchased some new clothes for $100 on the first day of the month and used a credit card to pay for them.
At the end of the month, your credit card statement arrives (for the sake of this simple example, let’s assume that this $100 clothing purchase is the only time you used your credit card that month).
But the credit card company is nice enough to let you make only a minimum payment of say, $10. Wanting to hold on to as much of your cash as possible, you go ahead and make just the minimum payment on the card on the due date.
Using basic math, you would think that a $100 initial balance minus your $10 payment means you now owe the credit card company $90, but this isn’t actually how credit card debt works! Borrowing money on credit isn’t free — and if you’re not careful, this is where you can start to get into trouble.
Depending on the credit card company and other factors such as your credit score (a higher credit score usually means a lower interest rate and vice versa), you may find that the interest rate charged on your balance is in the neighborhood of 20% or higher!
There are a few primary ways that credit card companies calculate interest, but we’ll use the simplest one — the daily average balance method.
Credit card companies will average your balance for every day of the month, then multiply that by the daily rate and the number of days in the billing cycle to determine your interest owed.
There are 3 pieces of information you will need to know to make this calculation:
- Your daily periodic rate, or DPR
- Your average balance on your card
- Days in the billing cycle
Daily Periodic Rate
Since an APR is an annual rate, your credit card issuer will divide that number by 365 to determine a daily interest rate. If your APR is 20%, for example, the daily rate would be 0.054% (or 0.000548).
Some cards use 360 days, so be sure to check your specific terms.
As we mentioned above, you’ve spent $100 on the first day of the month. You use the previous month’s daily average balance in order to calculated interest owed in the current month, so your average balance is $100.
This obviously gets a bit more complex once you factor in interest owed and minimum payments made, so we’ll walk you through the next month, too.
Your starting balance in month 2 is still $100 since you haven’t made a payment. Let’s say you made that payment on the 15th day of the month. You also have to factor in the interest owed as well. That would mean that your average daily balance for month 2 is:
((100*15 days)+(91.64*15 days))/30 days = $95.82
Days in Statement Period
Let’s keep it simple and assume all months have 30 days.
To calculate your interest fees for the month, your credit card issuer multiplies the average daily balance by the number of days by the DPR.
$100 average balance x 30 days x 0.000548 DPR = $1.64 in interest owed
The total balance you now owe after your $10 payment is $91.64. Let’s run with this example to see how it plays out in later months.
Example of Credit Card Interest Accumulation
|Month 1||Spend $100 on Clothes|
- Owe $100
- Get charged $1.64 in interest
- Pay $10 to reduce the balance to $91.64
- Owe $91.64
- Get charged $1.58 in interest
- Pay $10 to reduce the balance to $83.22
- Owe $83.22
- Get charged $1.44 in interest
- Pay $10 to reduce the balance to $74.66
- Owe $74.66
- Get charged $1.30
- Pay $10 to reduce the balance to $65.96
- …and on and on!
At this rate, it would take you a little over 12 months to pay off this debt and you would have incurred over $11 in interest (or more than 10% of your original item).
Other credit card issuers use a method called Daily Balance for calculating interest. With this method, interest is calculated based on your balance on each individual day in your billing period.
Interest can be compounded daily or monthly for this method, depending on the terms of your card (which will result in even higher rates than our example above!).
To find out exactly how interest is calculated on your credit card, be sure to read your cardholder agreement.
The key here is not to let your credit card balances get out of hand.
If possible, try to pay them in full each month. Otherwise, it could equate to a very high-interest loan on items that are not likely to increase in value.
The Different Types of Credit Card Fees and Charges
Some of the most common credit card fees and charges include:
Annual Percentage Rate (APR)
As discussed above, the Annual Percentage Rate, or APR, is the cost of borrowing money on an annual basis. If you’re late in making your monthly payment to the credit card issuer, you may find that they will increase your APR.
Some credit cards come with an annual fee just for the privilege of using them. This fee could be $50, $100, or even more. While you may not like paying an annual fee, some credit cards can be well worth it if they offer attractive rewards.
If you do not make your credit card payments on time, you can be hit with a late fee. These fees are typically in the range of $30 to $50 per occurrence, but they could be more depending on the card.
To avoid the late fee — and a potential rise in your interest rate — be sure to make your credit card payment on time each month.
Over Limit Fee
Credit card companies will almost always put a limit on how much credit you can use. If you go over this limit, the card company will typically charge you a fee (usually called an “over-limit fee”).
Before you make any purchases — especially large ones — make sure that you know exactly what your credit limit is.
Cash Advance Fee
There are many credit cards today that will allow users to take a cash advance. In fact, some card companies even advertise this by sending users “checks” in the mail that simply need to be signed and cashed.
But before you rush to your local bank or ATM, you should know that most credit cards will charge you a fee for this type of transaction. That fee is in addition to the interest you will be charged on your outstanding balance until you have repaid the cash advance.
How Too Much Credit Card Debt Can Impact Your Credit
Using credit cards wisely — which includes making timely payments on your statement every month — can help you raise your credit score. But just the opposite can also be true: having too much credit card debt can negatively impact both your credit score and your credit report.
Your FICO score is used in more than 90% of U.S. lending decisions, so it’s important to gain (and keep) a high FICO score to improve your odds of credit approval and getting more attractive interest rates.
There are 5 categories considered when determining your overall credit score. Each of these carries a different percentage weighting in terms of importance. These include:
- Payment history — 35%
- Amount of debt — 30%
- Length of your credit history — 15%
- New credit — 10%
- Credit mix — 10%
Nearly a third of your overall credit score is based on how much debt you carry. This particular component of your score includes several factors, such as:
- The total balance you owe
- How many of your accounts have balances
- How much of your available credit you are using
Hot Tip: The specific types of accounts where you owe money are also taken into consideration. For example, if you owe $50,000 on a home mortgage, it is considered much more favorably than if you owe $50,000 on a credit card — especially if you are at or near your total credit limit.
Tips for Using Credit Cards to Your Advantage
Having 1 or more credit cards can provide numerous benefits. In addition to allowing for quick and convenient transactions, many cards now offer various points, rewards, and/or cashback on purchases.
But spending too much money on your credit card or not paying off your balance every month can end up being costly. By following some helpful tips, you can get into good habits and learn to use credit cards to your advantage.
If you don’t have any prior experience with credit cards, be sure to start small. In other words, don’t charge too much at once — and again, make sure you can pay off the full balance amount when you receive your statement each month.
Make Your Payment on Time
Always pay your credit card bill on time, even if you are not able to make the full amount. Timely payments can significantly impact your score, too; in this case, it’s better to leave a balance on your card than reduce your credit score by making your payment late (while also incurring a late fee from the credit card company).
Hot Tip: If you’re in a real bind and need more time to clear off your balance and therefore reduce your interest payments, then you could look into transferring your balance to a credit card with 0% intro APR on balance transfers.
Determine Needs vs. Wants
When it comes to making purchases, having a credit card can definitely open up a whole new array of options. Unfortunately, this can result in a sizable balance each month, often racked up for items you really don’t need.
With that in mind, make sure to only purchase items you truly need with your card and ensure you can make the payment when it comes due. Otherwise, you may need to forgo certain purchases.
Don’t Sign up for Unneeded Credit Cards
While it may be nice to receive a “free welcome bonus” that is being offered by a credit card issuer, be careful. If a card vendor asks you to apply for their card, keep in mind that doing so will typically require the company to check your credit, which can result in lowering your credit score.
Cut up or Hide Your Credit Card(s)
In extreme scenarios, you may need to consider cutting up or hiding your card(s) so you don’t make any more purchases on credit. Even though doing so can make your financial life a bit less convenient, it can also help ensure that you don’t rack up any more charges (and the corresponding interest) on your card(s).
When It Makes Sense To Use a Credit Card (and When It Doesn’t)
Using credit cards to make purchases can offer ease and convenience. But just like most other things in life, there are times when it can make sense to use credit cards… and times when it doesn’t.
Overall, it can make sense to use a credit card if:
- You are able to pay off your balance in full each month
- The rewards you’re accumulating are worth more than the cost of the card
- You want additional fraud protection on your purchases
- You want to build or improve your credit score
Alternatively, it can make sense not to use credit if:
- You already have a considerable amount of credit card debt
- Using a credit card would only add to your debt balance(s)
- You are working hard to stick to a budget and be more mindful of your spending habits
In these cases, using cash or debit could be more beneficial for you — even if you only need to do so for the short term.
Hot Tip: If you’re unsure of the differences, see our article on debit cards vs. credit cards to learn which may be best for you.
Credit cards can allow you to make more (and larger) purchases without the need to apply for a loan, and without having to wait until you have enough money in the bank to pay cash for an item or a service.
But when you use credit cards, it’s also imperative to look out for interest and other charges, as these can make the cost of your actual purchase much higher. Using the right type of credit card responsibly can benefit you in many ways, including the accumulation of various points or rewards.