How does credit card interest work?
When you use your credit card, you’re borrowing money from the credit card company with the option of repaying the entire borrowed amount by the due date on your statement or paying a minimum monthly payment with interest, which is added to the balance for as long as it remains unpaid. For every month that you don’t pay the total balance due, you must pay the minimum monthly payment, including the interest charge. The APR that credit card companies charge is often charged on your statement as a Daily Periodic Rate (DPR). The DPR is a fraction of the APR that is calculated by dividing the APR by either 360 or 365, depending upon the issuing bank. The DPR is applied daily to the outstanding balance, causing the total amount due to compound. If your credit card balance remains unpaid for a long time, you can expect to pay a lot more than you may have originally anticipated, which is why it’s important to pay credit card balances off as soon as possible.
Calculating credit card interest
A good way to figure out the interest you’re paying on your unpaid credit card balances is to use the DPR. To get your DPR, find out whether your bank calculates their APR on a 365 or 360-day basis. You can usually locate that information in the fine print on your monthly credit card statement. You divide the APR by 360 or 365 to get your DPR. For example, if your APR is 12.25% and your bank considers a year to be 365 days, you’d divide 12.25% by 365 to get a DPR of .03%. This is the amount that is applied daily to your unpaid credit card balance, and it compounds over time if the balance remains unpaid. You also need to calculate your average daily balance, which can sometimes be found on your credit card statement. If your credit card statement doesn’t show the average daily balance but itemizes daily balances, add the daily balances together and divide them by the days in the billing period to get the average daily balance. Using a hypothetical average daily balance of $245.00 multiplied by a DPR of .03%, we get .0735. Then, when we multiply that number by the number of days in the billing period (let’s assume 30), we get $2.20. If the balance were carried over twelve months, you’d be paying about $26.40. However, since the interest on unpaid credit card debt compounds, you may pay more than that over a year if you don’t pay off your credit card balance sooner.
Understanding your APR
Credit card interest rates can vary based on your credit score, the type of card being offered and other factors. If you have good credit, you will be offered a lower APR, and if you have an average or poor credit rating, you can expect a higher APR. The APR can fluctuate if the credit card issuer uses a variable APR, charging you the base interest rate of your credit card plus the rate reflected in the Prime Rate set by the Federal Reserve or using other indexes. The Federal Trade Commission mentions that the credit card issuer must disclose the interest rate before activating your account and include it on your credit card statements, along with information about how much and how often your interest rate may change. The interest that is applied to an unpaid balance can vary even more over time. For instance, if a balance remains unpaid, the unpaid balance will be charged at the original interest rate. However, a higher interest rate may be charged for new purchases because unpaid balances signal a higher credit risk to the credit card issuer. On the other hand, you may have been offered a low promotional interest rate to sign up for a credit card or to transfer an existing balance to a new credit card from another account. The low promotional rate will expire, and you’ll then be charged a higher rate after the promotional period. Also: Best business credit card with 0% APR If you are being charged different interest rates, you should be able to see an itemization on your credit card monthly billing statement, categorized by type, such as “Unpaid Balance,” “Balance Transfers,” and “New Purchases.”
How to avoid paying credit card interest
The best way to avoid paying any credit card interest is to pay your entire credit card balance before the due date. Many credit cards have grace periods – the amount of time between when an expense is charged and when it is due for payment. You won’t be charged any interest if you pay your entire credit card balance during the grace period. In addition to not paying interest, if you use your credit card regularly and pay your balance due every month before the due date, the credit card company may reduce your APR because you’re demonstrating good credit habits. Another way to reduce your credit card interest is to transfer your credit card balance from a higher-interest credit card to one with a 0% APR interest rate. Make sure to pay off the transferred balance before the promotional rate expires and reverts to a higher interest rate.
Are there limits to the interest rate a credit card company can charge?
No federal law limits the interest rate a credit card company can charge. However, the state where the credit card company is headquartered may have laws that govern interest rate limits. Interest rate limits are imposed for military service members. As of 2017, the Military Lending Act limits the amount of interest that active-duty military service members and covered dependents can be charged for credit card accounts. The Servicemembers Civil Relief Act (SCRA) limits the interest rate to 6% for credit card debt that was incurred before starting active military service (active duty). If you have active-duty status, you can qualify for the 6% interest rate cap; you’ll need to notify the credit card issuer in writing and send them a copy of the military orders calling you to active duty so that they can calculate the interest rate reduction for debt that you incurred before attaining active-duty military status. [This article was first published on The Simple Dollar website in 2020. Updated in March 2022.]
