Shopping with credit cards is easy, convenient and secure. However, like most conveniences, credit cards come at a price. In addition to any annual fees you may pay on your card, the main cost of using a credit card comes in the interest you pay on the money you use for credit purchases.
To keep your costs down, it pays to seek the card with the lowest rate you can get, and to understand how credit card interest is calculated, how and when it is charged on your purchases, and how to avoid or minimize interest charges.
By U.S. law, credit card issuers characterize interest rates in a standard way, in the form of an annual percentage rate, or APR. The APR is the amount of interest you’d pay on a balance over a 12-month period. For example. on a card with an APR of 17.0%, if you carried a $1000 balance for one year, you’d be charged $170 in interest.
APR comparisons are helpful when you’re trying to choose among card offers, or deciding which cards to apply for. The lowest APR card you can get is usually preferable, although you should also consider factors such as spending limits and annual fees before making a final choice.
Cards that offer cash advances typically use a different (higher) APR for them than they do for regular purchases. Cash-advance APRs, which can be five or six points higher than the purchase APRs, are not featured prominently in card-marketing materials. If a cash-advance option is something you’ll use regularly, compare the applicable APRs carefully when considering a card offer.
What Determines the APR You Get?
When it comes to assigning credit card interest rates, card issuers place a lot of importance on credit scores such as the FICO® Score. A three-digit number between approximately 300 and 850, your credit scores are derived from the contents of your credit report at one of the national credit bureaus (Experian, Equifax or TransUnion).
People with lower credit scores are statistically more likely to default on their loans than those with higher credit scores. If your score is too low (typically below 600 or so) lenders, including card issuers, generally won’t extend you credit. Otherwise, credit card issuers typically charge higher interest rates to people with lower scores, an industry-wide practice known as risk-based pricing.
Credit scores aren’t the only criteria for assigning interest rates, but they are often the first test of whether you qualify for a card with a particular interest rate. Before making a final decision, credit card issuers may verify additional information such as your:
- Employment Status
- Mortgage or Rent Payment
Credit card issuers also use credit scores to promote and market cards with different interest rates. They might send pre-approval or prescreened offers in the mail for credit cards with the lowest interest rates (and most enticing rewards) only to people with credit scores over 750 or 800, for example. If you have lower credit scores, the same card issuer might mail you an offer for a different card, with a higher APR and less attractive incentives.
Fixed Interest Rate vs. Variable Interest Rate
An important consideration when comparing credit card interest rates is whether the card rate is fixed or variable. A fixed rate will remain unchanged until the lender notifies you otherwise, while a variable rate is linked to a published market index, such as the U.S. prime interest rate.
As the index changes, so does your interest rate: To calculate a variable rate, you add a specific amount, known as the margin, to the value of the index at any given time. The applicable index and the margin value are specified in the cardholder agreement.
Introductory Interest Rates
Many variable-rate credit cards offer attractive low introductory rates, which switch after a specified period (typically a year) to the variable rate. That change can lead to a significant jump in charges, particularly if you have a sizable balance that persists from month to month.
While the shift from a low introductory rate can be jarring, it may be prudent to get a card with a low introductory rate if you can use it for a balance transfer from a credit card with a higher interest rate. Naturally, if you do so it’s a good idea to try to pay off as much of the balance as possible before the introductory rate expires.
The grace period is typically restored once you pay off your balance on full, but some credit cards maintain the grace-period suspension for one or more months after you’ve paid up in full. All purchases made while the grace period is suspended are subject to interest charges starting on the day of purchase. Those charges, plus those on the outstanding balance, can add up pretty quickly. It’s good to be aware of them and to try avoiding them when possible.
How APRs Can Change
If a card has a variable interest rate, it is subject to change when its underlying index changes. When the card issuer increases the APR on a fixed-rate credit card, however, it is required to give you 90 days’ notice and the option to “opt out” of the increase.
If you opt out, you can continue to pay off your balance at the current APR, but no new purchases will be permitted. This amounts to closing the account. Because closing credit card accounts can have negative effects on your credit scores, opting out is a decision you should consider carefully.
If you wish to avoid the costs associated with an interest rate increase, you can consider alternatives such as seeking a balance transfer to a card with a lower rate, or using a debt consolidation loan at a lower rate to pay off the balance so you can keep the account open.
Calculating Actual Interest Charges
While APR is useful as a yardstick for comparing card offers, it’s not particularly useful for calculating the charges you’ll see in your card statement: Maintaining a steady balance over a one-year period is unlikely at best, and card issuers bill monthly, not annually, after all.
So if you’d like to know the amount of interest you’ll be charged in any given month, you need to do a little math. But first you’ll need to take a look at the fine print that accompanies the credit card.
For cards you’re considering applying for, look in the cardholder agreement that comes with the card offer; for cards you’ve already obtained, you can consult the disclosure in your billing statement. Look for a section heading that reads something along the lines of “How we calculate interest charges.”
Look for information on:
- The number of days that are used when calculating the daily periodic rate
- The number of days in the billing cycle
- Whether interest is applied using the daily balance method or the average daily balance method
Armed with this information, you can do the following:
1. Calculate the Daily Periodic Rate
You can calculate the daily periodic rate by dividing the APR by the number of days in an annual billing cycle—typically 365, but sometimes 360 days are used instead.
For discussion purposes, let’s assume your APR is 17.0%, and that there are 365 days in the annual billing cycle.
Your daily periodic rate is: (17.0% / 365) = 0.046575%
2. Determine the Number of Days in the Billing Cycle
Next, figure out how many days are in the billing cycle you’re calculating. This is usually the number of days in the calendar month.
Let’s use March, with a 30-day billing cycle, as an example. Using round numbers for convenience, let’s further assume the account reflected the following activity for the month:
- The opening balance, carried forward from February, was $1000.
- A $200 purchase posted on the 6th of the month.
- A $50 credit on a returned item posted a week later, on the 13th.
- A $40 charge posted on the 23rd of the month.
Methods of Calculating Interest Charges
Depending on which method is used on your card, calculate the charges as follows:
Daily Balance Method
The daily balance method applies the daily periodic rate to your balance for each day of the billing cycle.
Your monthly charge for March = [Balance on Day 1 x Daily Periodic Rate] + [Balance on Day 2 x Daily Periodic Rate] + … [Balance on Day 30 x Daily Periodic Rate]
Using our 17% APR example, if you begin March with a $1000 starting balance (and don’t make any new charges on March 1), your interest charge for day 1 will be $1000 x 0.046575% = 46.575 cents. Add that to the starting balance, and you get your day-2 balance of $1000.47.
Multiply the daily periodic rate again by the day 2 balance and add the result to get the day 3 balance, and so on. Repeat for each of the 30 days of the billing cycle, adding new charges to the daily balance and deducting credits.
In our March example, taking into account the $1000 initial balance, plus the $200 and $40 charges and the $50 credit, this yields a total monthly interest charge of $16.14, and a month-end balance of $1206.14.
Average Daily Balance Method
The average daily balance method applies the periodic daily rate to your average outstanding balance over the course of the month.
To calculate charges using this method, begin by calculating your average daily balance over the course of the billing period: Add up the balances for each day of the month, taking into account any new charges and credits, and then divide the result by the number of days in the billing cycle.
In our March example, with a $1000 initial balance, charges of $200 and $40, and a $50 credit, the average daily balance works out to $1153.67.
Multiply that daily average by the daily periodic rate, and then multiply that by the number of days in the billing cycle to get your monthly interest charge: $1153.67 x 0.046575% x 30 = $16.12
Note that if you have outstanding balances for both purchases and cash advances, you may have to repeat this exercise for the cash-advance balance(s), using a daily periodic rate calculated from the cash-advance APR. Add the charges on cash advances to those for regular purchases to get your total monthly interest charge.
Avoiding Interest Charges
The purpose of this mathematical exercise is to expose the ways in which interest charges are applied, with a mind toward minimizing them.
1. Work the Grace Period
It sounds obvious, but if your card lets you avoid interest charges by paying off your balance within a month, doing so will save you money. Do so whenever possible.
2. Avoid the Minimum Payment Trap
Carrying any balance month to month means you’re continuously racking up interest charges, and paying the minimum charge each month means you’re scarcely making a dent in them, especially if you continue to use the card. If you find yourself unable to make payments well beyond the minimum each month, consider seeking some advice from a qualified credit counselor.
3. Build Good Credit Scores
Pay attention to your FICO® Score and develop good credit habits that promote score improvement. With a good record of on-time payments, you’ll find yourself qualifying for cards with lower APRs that can save you money.
4. Be a Wise Credit Card Shopper and User
Applying for credit cards every month or two can lower your credit scores, which reduces the likelihood of you getting approved for the best APRs you deserve.
Study card terms carefully and once or twice a year, when your credit score has had at least three months to recover from the impact of any other loan applications, see if you can get a credit card with a better APR than the one you’re using today.
As long as you manage it well, an additional credit card will tend to improve your credit scores, and the lower APR will mean savings on the purchases you make.