The interest is usually calculated in the form of an APR (Annual Percentage Rate). Technically, it’s a single percentage number that represents the actual annual cost of funds over the life of the loan. This includes any additional fees or costs associated with the transaction. Interest is applied each month until your debt is paid off.
This means that while you are taking action to pay off your debt each month, this debt is also growing a little more each month. Under normal circumstances, payments are more than accrued interest; so each time you make a payment, you pay the additional interest in that month, plus some of the original debt.
As a result, you pay a significant portion of the money to the creditor or lender before your debts are paid in full. The larger the debt and the longer it takes to pay off, the more money you will have to pay in interest.
How credit card APR works
Interest charges only apply to credit card debt if you carry a balance from month to month. If you start a billing cycle at zero, then pay the charges in full within that cycle, no interest will apply. This is how you can use high APR credit cards without interest.
However, if you start a billing cycle with an outstanding balance, the creditor applies interest charges to the debt. Is that how it works:
- First, the creditor calculates a periodic interest rate.
- This is the annual percentage rate divided by the number of “periods” (billing cycles) within a year.
- In most cases, you can calculate your account’s periodic interest rate by dividing the APR on your bill by 12.
- The creditor then applies the periodic rate to your average daily balance.
- This is the average balance you had each day of the month.
- The creditor multiplies the periodic interest rate by the average daily balance to calculate the interest charges accrued during the month.
- When you make a payment, the creditor deducts these accrued charges from the amount you pay.
- As a result, only a portion of each payment you make goes toward paying off principal; that is the actual debt you owe.
Credit Card APR Types
A credit card can have multiple interest rates that apply at different times. The main rate is known as the purchase APR or standard APR for purchases. This is the fee that applies when you use your card at a store, restaurant, or shop online. However, that’s probably not the only APR listed on your credit card statement.
Promotional / Introductory APR
This is a special rate that applies for some time after the account is opened.
- In most cases, it offers 0% APR for 6-24 months, depending on your credit score.
- After the promotional period ends, the standard APR for purchases takes effect.
Balance Transfer APR
This is the rate that applies to balances you transfer to the card from other accounts.
- Balance transfers offer a type of debt consolidation because they allow you to combine multiple balances on a single card.
- These cards often offer promotional periods, such as 0% APR or low APR on transfers for 6, 12, or 18 months.
- However, once the promotional period ends, this rate tends to be higher than the standard rate for purchases.
Cash Advance APR
This fee applies only to cash you withdraw if you use your credit card at an ATM.
- You can use a credit card to withdraw cash just like a debit card, but interest charges apply.
- This rate tends to be much higher than most other card rates.
- Most experts do not advise the use of credit cards for cash advances, because this rate is very high.
This is the rate the creditor imposes if you miss a payment for more than 60 days.
- Instead of applying the regular purchase APR, they apply a penalty rate.
- The average penalty APR is 29.99%
- You must make six consecutive payments on time to remove the penalty APR and restore your standard rate.
How do credit card companies determine my rate?
There is no fixed rate, not even for a specific credit card. Your Capital One® Venture® Card rate may be significantly different than your neighbor’s rate. That’s because creditors use a combination of factors to determine your individual rate.
How high or low your credit card APR is largely based on the following:
- The Federal Reserve benchmark interest rate at the time the account is opened. The current reference rate (in English) is between 0% to 0.25%.
- Your credit score.
- The type of card you want to open. For example, reward credit cards typically have a higher APR.
If you have excellent credit and apply for a low APR credit card when the Reserve lowers interest rates, you minimize interest charges. Changes in circumstances may change your rates.
IMPORTANT NOTE: Credit card APR may change!
Most (not all) credit cards have variable interest rates. That means the APR can change based on what’s happening with the economy. If the Federal Reserve raises benchmark interest rates, expect their rates to rise as well. So, if the Federal Reserve raises the rate by 0.25%, then you could also see your credit card APR increase.
Of course, if the economy is weak and the Fed lowers interest rates, that’s good for anyone with balances on their credit cards. Your debt may be a little easier to pay off. However, most credit card companies won’t lower their rates as fast as they raised them after a Fed rate hike.