Understanding Credit Card Interest

Credit card companies make money in two ways. One is the fees they charge retailers, restaurants, and other sellers of goods and services when you use your card to buy something. The other is the interest and fees they charge you. Here is how credit card interest works—and how you can pay less of it.

What Is Credit Card Interest?

Interest is what credit card companies charge you for the privilege of borrowing money. It is typically expressed as an annual percentage rate or APR.

Most credit cards have variable APRs that will fluctuate with a particular benchmark, such as the prime rate. So, for example, if the prime rate is 4%, and your credit card charges the prime rate plus 12%, your APR will be 16%. Recently, the average APR of credit cards tracked in Investopedia's database was 19.62%.

With most credit cards, you are only charged interest if you don't pay your bill in full each month. In that case, the credit card company charges interest on your unpaid balance and adds that charge to your balance. So if you don't pay off your balance in full the following month, you'll end up paying interest on your interest. This is how credit card balances can grow rapidly and sometimes get out of hand.

To further complicate matters, some credit cards charge multiple interest rates. For example, they may charge one rate on purchases, but another (usually higher) one on cash advances.

How Credit Card Interest Works

If you carry a balance on your credit card, the card company will multiply it each day by a daily interest rate and add that to what you owe. The daily rate is your annual interest rate (the APR) divided by 365.

For example, if your card has an APR of 16%, the daily rate would be 0.044%. If you had an outstanding balance of $500 on Day One, you would incur $0.22 in interest that day, for a total of $500.22 on Day Two. That process continues until the end of the month. If you had a balance of $500 at the beginning of the month and added no other charges, you would end up with a balance of $506.60, including interest.

What Is a Good Interest Rate for a Credit Card?

Credit card interest rates vary widely, which is one reason to shop around if you're looking for a new card. Typically, the better your credit, as represented by your credit score, the better the rate you'll be eligible to receive. That's because the credit card company will consider you to be less of a risk than someone with a lower score.

In shopping for a credit card, knowing your credit score and the range into which it falls (such as excellent, good, fair, poor) can help you determine which cards and what kinds of interest rates you might be eligible for before you apply. You can obtain your credit score for free at a number of websites and also from some credit card companies. Note that your credit reports, which you can also obtain free of charge at AnnualCreditReport.com, do not include your credit score.

Repaying Credit Card Debt: Two Interest Scenarios

Let’s say John and Jane both have $2,000 balances on their credit cards, which require a minimum monthly payment of 3%, or $10, whichever is higher. Both are strapped for cash, but Jane manages to pay an extra $10 on top of her minimum monthly payment. John pays only the minimum.

Each month John and Jane are charged interest on their cards’ outstanding balances at an APR of 20%. When John and Jane make payments, part of their payment goes to paying interest and part toward principal (their balance).  

Here is a breakdown of the numbers for the first month of John’s credit card debt. (For the sake of simplicity, we're showing the interest calculated on a monthly, rather than daily, basis.)

• Principal: $2,000
• Payment: $60 (3% of balance)
• Interest: ($2,000 x 20%)/12 months = $33.33
• Principal Repayment: $60 - $33.33 = $26.67
• Remaining Balance: $1,973.33 ($2,000 - $26.67)

These calculations are carried out every month until the credit card debt is paid off.

If John continues paying only the minimum, he will spend a total of $4,241 over 15 years to pay off his $2,000 in credit card debt. The interest alone will have cost him $2,241.

Because Jane is contributing an extra $10 a month, she'll pay a total of $3,276 over seven and a half years to cover her original $2,000 in credit card debt. Her interest charges will total $1,276.

The extra $10 a month saves Jane almost $1,000, compared with John, and cuts her repayment period by more than seven years.

The lesson here is that every little bit counts. Paying twice your minimum or more can drastically cut down the time it takes to pay off the balance, which leads to lower interest charges in total.

Of course, while it's good to pay more than your minimum, it’s better not to carry a balance at all.

Why Pay Your Balance in Full?

As an investor, you would be thrilled to get a yearly return of 17% to 20% on a stock portfolio, right? In fact, if you were able to sustain that kind of return over the long term, you should probably be running your own hedge fund.

Paying off a credit card balance is much like getting a guaranteed rate of return on your investment. If your credit card charges 20% interest per year and you pay off the balance, you are guaranteed to save yourself 20%, which, in a way, is the equivalent of making a 20% return.

So, when you have some cash to spare, it is almost always better to use it to reduce your credit card debt than to invest it. If you can pay off your balance and stop paying credit card interest altogether, you'll find you have more money to invest in the future.

One interim strategy to consider, if you're eligible, is transferring your current credit card balances to a balance transfer credit card with a lower interest rate. Many of these cards have promotional periods of six to 18 months over which they charge 0% interest on your balance, which can stop the clock on further interest charges and allow you to pay your balance down faster. Just watch out for any balance transfer fees, which can add 3% to 5% to your existing balance.

And, whatever you do, remember to keep paying.