No one wants to pay interest on credit card purchases, but you won’t have a choice if you have a balance. Understanding how your credit card interest is calculated can help you understand the steps you can take to minimize the interest you have to pay. However, you might be surprised at how difficult it can be to manually determine your credit card interest charges if you want to double-check your card issuer’s work.
How does credit card interest work?
APR vs interest rate
All credit cards have interest rates which are displayed as APR, which stands for Annual Percentage Rate. You can think of an APR as a standard unit of measuring interest charges over time. However, even though the APR is expressed as an annual percentage, it can be used to determine interest charges over any period of time, not just a year.
Almost all credit cards use a variable APR. This means that your interest will vary with the prime rate, which rises and falls based on the monetary policy set by the Federal Reserve. For example, if the Prime Rate is 4.25% and the Card Base Rate is 10.74%, you will have a Variable APR of 14.99%.
Fortunately, the prime rate usually doesn’t change dramatically. Increases in APR due to increases in the prime rate will not have as much impact as other triggers, such as a late payment.
Types of credit card interest
There’s usually more than one interest rate associated with your credit card, depending on how you use it. Here’s an overview of the different types of credit card interest rates you might encounter.
- Fixed rate: A fixed interest rate does not change; it remains the same from month to month.
- Floating rate: A variable interest rate fluctuates over time based on certain indices or other factors. Most credit cards have variable rates.
- Promotional or introductory: Often, credit card issuers offer lower promotional rates to existing and new customers in order to generate more business. Sometimes this rate can be as low as 0% APR. However, once the promotional period ends, the interest rate will reset to the standard rate.
- Cash advance: Cash advances allow cardholders to withdraw cash, by borrowing from their available balance. Often, cash advances come with a higher rate than regular purchases and start earning interest immediately. They may also come with additional charges.
- Balance Transfer: A balance transfer involves moving the existing balance from one card to another card, often for a temporary lower rate or even 0% APR. Balance transfers also come with a one-time fee in most cases, equal to a few percentage points of the transferred balance.
What determines the interest rate of a credit card?
A credit card company bases its interest rate on a few factors, including the current prime rate, the information in your card application, and your credit score. Card issuers tend to reserve their lowest rates for customers with good to excellent credit. If your credit is considered when approving (or not) your card application and setting the interest rate, the creditor must tell you the credit score used and the specific credit factors that led to the decision.
How to Calculate Credit Card Interest
Curious about how much interest you’d pay if you carried over a balance from month to month? Here are some basic steps you can follow to calculate credit card interest.
- Find your DPR. Many credit card issuers calculate your interest using a daily periodic rate, or DPR. This rate is multiplied by the amount due at the end of each day and then added to the balance from the previous day. You can calculate the DPR by dividing the APR by 360 or 365 days, depending on the card.
Follow this formula instead. To more easily estimate your approximate interest charges for a single month, you can first divide your APR by 12 to find your monthly rate as a percentage. You can then multiply your monthly percentage rate by your average daily balance to estimate your interest charges.
For example, if your account has an APR of 25%, your monthly percentage rate will be 25%/12, or 2.08%. If your average daily balance is $1,000, you will incur approximately $20.80 in interest in a single month.
Keep composition in mind. Note that this estimate will not take into account the compounding effects of adding yesterday’s interest to your balance each day. However, daily compounding will only add a small amount to the monthly interest charge unless you have a particularly high interest rate or balance.
Estimating your average daily balance can be difficult if you continually add new charges or subtract additional payments throughout the month. Nevertheless, this method can be useful for estimating how much interest will accrue each month on a fixed balance or one that remains within an approximate range.
What is a good interest rate on a credit card?
In general, a good interest rate on a credit card is considered below average. The average credit card rate is 16.65% APR in the second quarter of 2022, according to the Federal Reserve. So if you can find a credit card with a rate lower than about 16%, that’s considered a good rate.
How to reduce your credit card interest charges
Since credit card interest is calculated on your daily balance, you can reduce your interest charges by continually trying to reduce your balance each day.
For example, you can make payments to your credit card account as soon as possible, rather than waiting for your payment to be due. You can avoid increasing your daily account balance by postponing purchases for as long as possible, especially larger ones.
If you have strong credit or have held the card for a while, you may be able to negotiate a lower interest rate with your credit card company.
How to avoid interest on a credit card
At the same time, it is possible to completely avoid credit card interest. “Pay off the purchase in full during the grace period, and you’ll pay no interest or fees,” says Robert Farrington, founder of financial literacy website The College Investor.
During a credit card’s grace period, the credit card issuer waives interest charges between the statement closing date and the payment due date. You must have a zero balance at the start of each month to use the grace period the following month. So, if you carry a balance from month to month, you won’t be able to avoid interest charges by paying off that month’s statement balance in full. However, paying the balance on your next statement will allow you to avoid interest charges the following month.
If your card has a grace period, it should last at least 21 days. Many credit cards have a 25 day grace period. However, some cards marketed to applicants with bad credit may not have a grace period at all, so new purchases start earning interest immediately.
It is important to note, however, that grace periods do not apply to cash advances. “They start accruing interest from the day you receive the money,” says Farrington.
Another way to avoid interest charges is to take advantage of introductory offers of 0% APR on new purchases, balance transfers, or both. These offers will allow you to avoid interest charges on your balance for a limited time, usually between 6 and 21 months. Interest only begins to accrue on your remaining balance after the introductory period has expired. It’s common for credit card issuers to offer 0% APR offers to attract new customers, but you can also ask your existing card company for limited-time offers.
Keep in mind that many store credit cards offer deferred financing options that calculate interest differently than those with 0% introductory APRs. With deferred financing, interest accrues on your average daily balance, but is forfeited when paid in full before the end of the promotional financing period.
However, credit cards that offer deferred interest can also have drawbacks. If the balance is not paid in full at the end of the promotional period, accrued interest will be charged. Late payment may trigger deferred interest.
Calculating your credit card interest charges manually isn’t easy, but it’s important to know how the process works in order to avoid the negative effects of compound interest.
Farrington suggests treating your credit card like a debit card: only spend what you really need and pay it back each month, on time. It’s the only way to avoid interest and fees, like late fees, and ensure the rewards you earn don’t cost more than they’re worth, he says.