How Does Credit Card Interest Really Work?

When you want something today but don’t have the actual money for it, banks will offer you a credit card to pay for it now and allow you to take time to pay it off later. After that first purchase, they send you a bill and have a small amount listed with the minimum payment due. In years past, it used to be lower, but in 2009 US Congress passed a bill to make the amount around 2% of the balance owed. There were also other provisions in the bill that made banks show how long it would take you to pay off the amount if you paid the minimum and you never charged again. That is good for you, but how does the amount owed get calculated?

How is interest calculated?

Compound interest has a big impact on how credit cards actually work. If you carry a balance on your credit card, the amount is now compounded daily on the balance due by almost all credit card companies. Many people go out of their way to make sure they get a good Annual Percentage Rate (APR). This rate is used to predict the amount of interest paid in a given year. If the rate is say 15% it’s actually a little higher since the rate is compounded daily. As an example: Say you have a balance of $10000 and a daily interest rate of 0.041% (This is equivalent of an APR around 15%). So today you owe $10000 which would be multiplied by 0.041 which gives you a tomorrow balance of $10004.10. This process continues on day after day where your monthly bill comes due with a new total usually in excess of $10100. You are paying the bank a premium to purchase an item today, but to pay it back in the future with much more than originally purchased for. Banks hope that you don’t pay attention to the interest part of their agreement so that you’ll go merrily along paying them for the use of that plastic.interest_chart

When is interest calculated?

Almost all credit card companies give you a grace period of a month before calculating interest on the balance. You see your bill is calculated on the opening balance, any payments made during the month, any additional transactions (purchases) and interest is included in on what you owe. If you purchase anything within the transaction period and pay it off at the end of the month, the bank has given you basically a free gift of using the card to delay payment. The reason that this gift is available is because over 95% of credit card holders carry a balance. So everyone else is paying their partial balance with interest and in effect floating a short term loan to those that pay in full. Now penalties are assessed to anyone that fails to meet the payment due date. The can result in no 30 day grace period on purchases and/or increase in the annual interest rate, which of course increases your daily compound rate.

How a credit card interest rate is arrived at for you

Credit card companies base a new credit card on 3 factors; 1) prime interest rate 2) your FICO credit score 3) promotional offers. The prime rate is a rate governed by economic variables and is used as a base for all business transactions. It’s tied to the rate that banks borrow from the Federal Reserve. Prime is always 3 percent points higher that the federal reserve rate. It’s good to note that your interest rate will never be at the prime rate since banks pass along the borrowing rate and add 3 percent to the minimum interest rate. So if the rate the Fed is charging was zero, the interest rate for a consumer credit card would be at least 6 percent. FICO is a Software company based in San Jose, California and founded by Bill Fair and Earl Isaac in 1956. Its FICO score, a measure of consumer credit risk, has become a fixture of consumer lending in the United States. There are many variables that are used to compute credit scores, but mostly it’s a numerical indicator of your ability to pay. The higher the score, the less interest banks charge to allow you to borrow. Promotional offers are used when banks compete for your business. There may be airline miles, or cash back offers and even a year of free interest to entice you to go along with their program. These are usually available to individuals that have higher FICO scores. All of these methods will be calculated together to offer you a credit card interest rate that you will be happy with.

Pay them off quickly

The real way to work credit cards is to pay them off as quickly as you can. There may be situations that you need to carry a balance, however late payments can have a detrimental effect on all your business and for some time in the future. There is even a possibility if you miss the payment on one credit card and you have multiple cards, all of them can increase the interest rates. A late payment on a credit card can make purchasing a home or car much more expensive since this one error will stay with you for years down the road. Do yourself a favor, if you look like you’re going to run into problems with paying the amount dues, get with a credit agency that will work on your behalf to consolidate debt and get your life back in order.

About The Author

Thomas

A husband, father, brother, uncle and cousin to a great group. I'm an budding entrepreneur that has interest in making money that will sustain deep into retirement. At this point in my life I see no reason why I shouldn't get my piece of the pie.