How Does Credit Card Interest Work?

How does credit card interest work?

If you own a credit card – or if you’ve ever thought of applying for one – you have probably asked yourself: how does credit card interest work?

At first glance it seems relatively simple. But the details can be confusing. So we thought it would be useful to explain exactly how credit card interest works…

How Credit Card Interest Is Calculated

Surprise! More likely than not, you don’t realize exactly how the interest on your credit card is calculated.

In fact, credit card companies often rely on the fact that you will not understand how your interest is constantly compounding. Therefore, you need to protect yourself by understanding how compounding works in relation to credit card interest.

The term “compound interest” means that any interest charges are added to the principal (which is the amount you originally borrowed) so that your debt grows exponentially.

If you have a $100 debt and it accrues 10% interest every month, then the first month you will be charged ten dollars (100 x 0.10). With compound interest, that ten dollars is added to your original debt, so now you have $110 of debt. The second month you are again charged 10% interest, which this time comes out to eleven dollars (110 x 0.10), so now you have $121 of debt.

You can see how it begins to add up quickly!

Compound interest has a big impact on how credit card interest works. Most people know their APR, which stands for Annual Percentage Rate. In general, your APR is supposed to equal the approximate percentage you will pay in interest over the course of a year. However, the actual amount you will pay is often slightly higher than the APR. (See this explanation of the term “Average Daily Balance”)

These days, most credit cards compound interest on a daily basis, not monthly. For example, let’s say you have a revolving balance of $10,000 on your credit card, and your daily interest rate is 0.041% (which is approximately equivalent to an APR of 15%).

Multiply $10,000 by 0.00041 and you get $4.10, which means you’d pay $4.10 in interest on the first day. On the second day, your balance would be $10,004 and ten cents, and you’d pay interest on that total. Each day going forward, your interest would keep compounding until you had paid it off. Definitely not a pleasant thought!

It’s wise to read the fine print on your credit card statement so that you know exactly how the interest is calculated on your card.

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When Are You Charged Interest?

Most credit cards give you a grace period of about one month to pay the balance listed on your credit card bill. If you choose to pay only the “minimum payment due” or if you pay any amount less than the total balance, you’ll have to start paying interest on the remaining balance. (To see how minimum payments can get you in trouble, read The Myth of Minimum Payments)

Once that due date has passed, any leftover debt is considered a revolving debt and the credit card company will happily start charging interest on it. And your grace period of 30 days is also subject to being taken away if you don’t pay the full balance. In that case you generally have to pay on time for two months in a row (and pay off the entire balance both times) to get back your grace period!

It’s also worth noting that some credit card agreements allow the company to charge you interest on purchases you have partly paid off. For example, if you used a credit card to buy a new refrigerator for $500 and paid $400 off within the first month, you might still be charged interest on the entire $500 balance until you pay it off in full.

Factors That Affect Your Credit Card Interest Rate

Of course, understanding how your interest accrues is only half the battle. You also need to understand how your interest rate is determined in the first place and how it can change.

When you apply for a credit card, there are three main factors that affect your initial interest rate:

1. The “prime rate”
2. Your credit score
3. Promotional offers

Let’s take these one at a time:

1. The “prime interest rate”
You might wonder, “what the heck is a prime rate?” Good question. The prime rate is a kind of baseline interest rate that fluctuates over time based on certain economic variables. It’s tied directly to the federal funds rate, which is the rate banks pay for short-term borrowing from the Federal Reserve. The prime rate is always 3 percentage points higher than the federal funds rate.

At the moment, the federal funds rate stands at an all-time low of 0.25%, and the prime rate is at 3.25%. When you sign a credit card agreement, you commit to pay the interest rate that is set by the credit card company, and that can change along with the prime rate: if your current rate is 15% but then next month the prime rate is raised from 3.25% to 6.25%, your interest rate would also likely increase by 3 percentage points.

2. Your credit score
Different people can be eligible for different interest rates. When you apply for a credit card, the credit card company checks your credit score to see if you are a good credit risk, and if your score is good, you’ll be eligible for the best (lowest) interest rates. However, if your credit score is bad or average, you probably won’t qualify for those rates.

3. Credit Card Promotional offers
A third factor that can complicate things even more is the fact that credit card companies love to create special promotional offers that tempt you with ridiculously low interest rates – for an introductory period of usually 6 to 12 months. These are especially common for balance transfer offers, which often give you an introductory 0% interest rate for at least 6 months after which you pay a higher interest rate. If you can use one of these offers in order to pay off your existing balance during the introductory period, this may be a good deal for you. But if you fail to do so, the credit card company will usually charge you the higher interest rate retroactively on your entire balance.

That brings us to the fourth factor that affects your interest rate: your payment behavior. Unlike the three factors above, this one only affects your interest rate after you have signed the credit card agreement.

4. Your credit card payment behavior
If you do not pay your credit bills on time, your credit card company can (and usually will) increase your interest rate. The amount that it gets increased depends on the individual situation, but it can be quite a lot. (If you’re in this situation, make a plan to get out of debt as fast as possible – ReadyForZero can help)

Believe it or not, late payments on credit cards and loans can cause your interest rates to go up on all your credit cards. If you have several credit cards, a missed payment on one of them could affect the rates on all your other cards as well.

The bottom line is you must be informed about how all of these factors work together to determine your interest rate. Read your credit card statement carefully and make sure you know how the interest calculation works for your card. (See our article, How to Understand Your Credit Card Statement)

We hope that the information above has helped to answer the question, “How does credit card interest work?” If you have more questions, just let us know!

This article is part of our Credit Card Debt Resource Center.  If you’re looking for additional information about credit card debt, be sure to pay a visit!

Image credit: 401K

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  • Zack Jones

    This blog post should be required reading for anyone filling out a credit card application. GREAT information. Thanks for sharing it. We still have a credit card but always pay the full balance each month.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Thanks, Zack! That would be great if everyone applying for a credit card could read it. As always, please share with anyone who you think might find it useful!

  • http://www.modestmoney.com/ Modest Money

    Credit card interest can be confusing.  I personally make a point of always paying off my full balance each month so that I never have to worry about it.

    Also if you have used your credit card for a while, you can call them and request a lower interest rate.  This works especially well if you have another offer that you can mention that you are considering switching to.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      That is certainly the best way to do it! And you’re right about the potential benefits of requesting a lower interest rate. We agree, and we’ve written about how to do this:  http://blog.readyforzero.com/lowering-interest-rate-simple-phone-call/.

  • http://www.smartwealth.org/ Evan @ Smartwealth

    I try my best to make sure my card is fully paid off monthly.  When I was younger I had a hard time doing so, and I can’t imagine the amount of interest that was accruing on the interest that I had already been charged.  you live and you learn I guess.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      I’m the same way – I always like to pay off the balance in full each month. Except right now I have a balance on it that I’m working to pay off (you can read about it here: http://blog.readyforzero.com/credit-score-update/ )

  • Pingback: Financial Simplicity Carnival #4: The Rushified edition | Daily Money Shot | Daily Money Shot

  • Gabs

    Very informtative, thank you!

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      I’m glad you found it helpful! Thanks for your comment.

      • stephen

        Hey I have a secured credit card. If I pay the full balance every month will that build my credit score quicklt

        • http://www.twitter.com/bwfeldman Benjamin Feldman

          Hi, in most cases that would help you build your credit score. However, I can’t say how quickly it will happen. Each individual situation is different. Good luck!

  • asknavoda

    I had no idea that this is how it works. So basically if you make your payments in full, every month within the grace period, you should not be charged an interest am I correct?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Yes, as long as you pay your full balance by the due date every month then you should not be charged any interest. However, if you carry a balance for even one month, you will be charged interest going forward until you go two consecutive months of paying the balance in full. Glad you found this post helpful!

  • http://twitter.com/GinaGuerin24 Gina Guerin

    What formula could I use to determine the interest I would be charged if I do not pay off my credit card within the 0% introductory apr period?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Gina, it depends on your particular credit card agreement. I would recommend looking at the fine print to see what it says about any remaining balance you have after the introductory period. Some cards have exorbitant charges if you fail to pay the full balance before the introductory period is up.

  • http://www.facebook.com/alexandra.moise Alexandra Moise

    So if one was to always pay off their credit card balances in full EVERY month how would the lender/ company make money?? is there somehow else they charge to lend us the money?!?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Alexandra. Yes, there are other ways they make money (aside from interest). Many credit cards have annual fees which you must pay regardless of whether you carry a balance or not. And the credit card companies also charge store owners and retailers a “swipe fee” when you use a credit card at a store. They make a significant amount of money that way as well.

  • Full_Name

    Hi, are there any rules for how the creditcard company applies your payments? I have a 3500 balance transfer at 1.99 percent with one bank (valid for 3 years). At another bank I have another card with 750 balance with 20% interest. My 1.99% bank also sends me checks every month which I could use to get 0% interest. I.e. I could pay off the 750 and now I would have 0% interest on that. My question becomes. After a year, when that deal runs out, my 3500 would still be at 1.99 and the 750 would be at 16%. In this year, where does my payments go? Do they pay down the 750 or the 3500?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      I think you’re asking about who you would pay if you use the checks to pay off your $750 balance? In that case, you would end up paying the company who sent you the checks. However, that assumes I’ve understood your question properly. What might be helpful is to try using ReadyForZero (https://www.readyforzero.com) to organize all your debts and start paying them off. If you could pay off the $750 balance that would make your debt picture much more straightforward!

  • julia

    Thanks so much for the post. My question is my girlfriend wishes to pay her fees of 2000 with her card but the interest on it is 20%. Is it advisable to pay her fees with the card? and how much is she required to pay each month without any funny charges.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Julia, I’m not sure I understand your question. I’m also not able to provide detailed advice on an individual level. But if you could rephrase the question perhaps I can provide some resources that may be helpful in helping you find an answer. Thanks.

  • EnvyEyes

    So just to clarify, because I have never applied for or had a credit card before and I am 26 years old.

    When you get your bill originally, is it just your charges that you owe back or do they automatically begin charging the daily interest to everything from the day you swipe your card to the day your bill arrives in the mail and that will be included on it too?

    So that would mean even if I pay my bills in full on time everytime, that I still will be paying that extra daily interest so still I would be owing more money than I had actually spent.

    Correct?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Great question! In most cases, you will not be charged interest if you pay the full balance off every month (on time). In other words, you spend money, receive the bill, pay it in full – not just the minimum payment – and do not pay interest. But it is always a good idea to double check by reading the fine print on your credit card agreement or calling and asking a customer service representative to verify that this is true for your particular credit card.

      • EnvyEyes

        Great. Thanks.

        Because I’m weighing the benefits and disadvantages between getting a credit card or just dealing with Overdraft Coverage and the $36 Overdraft Fee.

        I was thinking of linking up a credit card so that overdraft would come from it and then there would only be like a $15 fee.

        I just didn’t want to get trapped naively in the pitfalls of a credit card and adding another bill to the table

        • http://www.twitter.com/bwfeldman Benjamin Feldman

          That is very smart to research all the angles before making a decision. Sounds like you are thinking about all the right questions!

  • Tiffany

    Thanks! helped a lot.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Thanks, Tiffany! I’m glad it was helpful.

  • Grant Douglas

    So if I spend $100 on my credit card with a 19.8 Apr but I pay the full amount every month will I be charges an Apr?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      No, if you pay your full balance every month by the due date then you will not be charged any interest. If you are, you should call the company to complain and consider filing a complaint with the CFPB.

  • ike1018

    Wish I would have read this a few months ago. I just got a real world example of this. I was off on my December payment by $18, I was charged about $18 in interest on my January statement. Here is the kicker, I paid my January statement IN FULL, but then still had a $29 interest charge added to that statement. So, for carrying over $18 for one month, with continuous use of my card, it cost me $47 in interest charges. Where I have the problem is, on month 2. They give you a statement with an amount and a due date. When you pay that amount, and in my case I paid over, I still got interest charges because I lost the grace period. To me that borders on Fraud.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Wow, yeah, that sounds exorbitant. They charged you $29 + $18 of interest just for carrying over a small balance? I can’t imagine what their justification for that is. You might want to submit a complaint to the CFPB: http://www.consumerfinance.gov/complaintdatabase/.

      • ike1018

        I don’t quite see how the math works personally, but the explanation I got is the daily compounding of interest on my running balance, since I left $18 I was charged the interest on the full running balance for that month. I paid over on my next statement balance but still got charged interest on that balance until my full payment was received. That’s the part I think borders on fraud. I get a bill, pay that bill on time, then still get additional interest charges from the statement date until payment even though it was prior to the due date. Thanks for the link.

  • ThatmtnGuy

    Situation Time….I got $1,500 on my card that is just now coming off of a year of 0% interest rate. My interest rate is 22.99%. How much will i get charged for the upcoming month in interest? Surely its not $344.85?? Also my minimum payment was set at $30. I reset it to $50 and have been throwing money at it in the past few months to get my principle down.

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Fortunately, the interest rate (or APR) is for the whole year, so to estimate what you’ll be charged next month you’d have to divide the $344 number by 12, which comes out to around $27. That sounds more manageable, right? Also, that’s great you are paying more toward your principal. Have you tried ReadyForZero yet? http://www.readyforzero.com. You might also find this article interesting: http://blog.readyforzero.com/what-does-apr-mean/.

      • ThatmtnGuy

        A good read. Thanks for the education. Stress level is down. Might just try to get it down to monthly business within the next few months nonetheless.

        Is there a reduction of credit score due to leaving debt on your cards? I really have been paying about $500-$700 monthly towards my card and using it as a debit card, to get points.

        Either way I prolly needed to know these things about a year ago to be more prepared for the credit world.

        • http://www.twitter.com/bwfeldman Benjamin Feldman

          I’m so glad the article was helpful! And you should congratulate yourself for learning about these things now. You’ll probably be more educated than the majority of people on these topics. It sounds like you’re on the way to having very good credit habits. If you can get that debt paid off and continue making all your payments on time, you will have a good credit score in no time. To learn more about credit and how to check your credit report for free, check out our Credit Score Resource Center: blog.readyforzero.com/resources/credit-score.

  • Vanessa Williams

    Thank you for this — You really explained it in a simple and very easy to understand way!!!

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Thanks so much, Vanessa! I’m really glad to hear that it was helpful. I hope you’ll stick around and read some of our other blog posts as well. If you’re interested, we created a community Facebook page too: https://www.facebook.com/groups/readyforzerocommunity/.

  • Steffany Watson-Jager

    OK my husband got a $10000 loan through his patents on their credit card. It had a 20% revolving percent interest. He has been paying $200 a month for 5 years. How far I to laying this plan off should he be. We r being told we still owe $9000

    • Steffany Watson-Jager

      After paying $200 a month for going on 5 years now

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Hi Steffany, yes, unfortunately credit card companies lull you into believing that you’ll pay off your debt with the minimum payments. Unfortunately, minimum payments are designed to keep you in debt for a nice long time. (Read this post for more details: http://blog.readyforzero.com/the-myth-of-minimum-payments/)

      So what this means is that even though you’ve paid $12,000 already, most of it has been eaten up by interest charges. So you still owe them $9,000 (that’s your principal balance). If you have a good credit score, you might want to try doing a balance transfer and switching to a card with a lower interest rate – 20% is too high!

      Also, read some of our posts (like this one: blog.readyforzero.com/how-to-get-out-of-debt) and use our resource centers (like this one: http://blog.readyforzero.com/resources/budgeting-tips/) to get inspired to pay off all your debt. I’d also recommend signing up for ReadyForZero (www.readyforzero.com) and joining our community: https://www.readyforzero.com/community. Good luck!

  • Jetski Dg

    Wow! I’m glad I read your post. I’m about to grab an offer with 22.9% APR!!! your article is very helpful. Thank you!

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      Thanks for your comment! I’m so glad to hear the post was helpful to you. Twenty-three percent would definitely be a high APR. If you want some more info, check out our Credit Card Debt Resource Center: http://blog.readyforzero.com/resources/credit-card-debt/.