As of June, 2010, the Federal Reserve estimates that Americans have approximately $827 billion in revolving credit, the majority of which is credit card debt. While that daunting amount of money doesn't reflect the average amount of debt each individual carries, it does stand to reason that the more consumers understand about credit cards, the better off they will be.
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Consumers often search for the best credit card rates they can find, but they may not understand why interest rates are set at any particular rate and how much of a difference a lower interest rate can make in their credit card payments.
Interest Rates and APR
The annual percentage rate (APR) is what a financial institution charges each customer on a loan or a credit card balance. Some credit card companies offer a low introductory rate for new customers and on balance transfers for six months or one year and others charge different APRs depending on how the credit card was used. For example, credit card companies usually charge a higher APR on cash advances than on purchases. Your interest rate is set by the credit card company and may be based on your credit score.
Fixed Rates Vs. Variable Rates
Credit cards will have either a variable APR or a fixed APR. If you have a fixed rate credit card, the interest rate might still change if you pay your bill late or not at all, or if the credit card company sends you a written notice of a rate increase. Variable APRs are normally tied to the prime rate, which is the interest rate banks charge to corporations. The prime rate usually adjusts when the Federal Reserve adjusts the Federal Funds Rate. When you read the fine print on your credit card agreement, you will usually see a statement with your rate reading as "Prime rate plus 8%" or something along those lines. (For more, check out Cut Credit Card Bills By Negotiating A Lower APR.)
When Interest Is Charged
Credit card companies begin charging interest after a balance is outstanding for one or more billing cycles. If you want to avoid paying interest, you need to pay your credit card balance in full before the due date each month. One other option is to have a zero interest credit card, but these will usually only offer a promotional zero-interest period, such as six months or one year.
Why Your Interest Rate Changes
Most credit card companies charge one rate for a purchase, another for a balance transfer and another for a cash advance. In addition, you may be charged a default or penalty rate if you are 60 days late paying your existing balance. If you go over your credit limit or are 30 days past due on your bill, the default APR will be charged on future transactions. The other reason your rate could change is that you signed up for the card at a lower introductory interest rate and that introductory period has expired.
Changes to Your Interest Payments
Consumers should be particularly conscious of the interest rate they are being charged by their credit card companies because the rate dramatically impacts the amount of interest you pay each month on your debt. For example, if you have a credit card with a balance of $2,000 at 18% interest and pay $50 per month towards that balance, you will pay $339 in interest alone over a 12 month period. If you can transfer that balance to a credit card with 9% interest, you will pay $162 in interest and save $177 over that 12 month period. The savings in interest could pay for 3.5 months of your monthly payments.
Many consumers opt to transfer balances to a lower interest rate or even a zero-interest rate if they can. But beware, most credit card companies limit these low-interest periods and charge a balance transfer free. Consumers need to make the calculation to determine if the amount they are saving on interest payments will be enough to offset any balance transfer fee. If the goal is to pay off your credit card debt, make sure to calculate how much you need to pay each month to reduce your balance to zero before the introductory rate expires.
The best way to make sure you pay the lowest interest rates on a credit card balance is to keep your credit score high. Credit card companies typically offer their best rates to the most creditworthy customers. (To learn more, see Understanding Credit Card Interest.)
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