How Does Credit Card Interest Work?

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by parag
Last Updated: January 18th, 2017
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KEYWORDS:#debt #tips #payoff #creditcard #Interest #Calculator #Debt
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Your credit card balance is $7000.00 and your minimum payment is only $150.00 per month. Sounds pretty good because you can afford that, right? One to two years later, your balance is now at $10,000 and suddenly you’re in a bit of a panic. You applied for credit and you were told you have too much debt. You’re thinking to yourself, “How did this balance get so high?” You discovered this revelation when you applied for additional credit, or for a loan for a major purchase such as an automobile and a home. You may have been approved for credit, but you were charged a ridiculously high interest rate and you asked why. 

We all know that banks make most of their money from charging interest on lending money to borrowers, including credit card holders. When you decide to carry a credit card balance from month-to-month, this interest begins to accrue. Most banks profit from people who do not understand compound interest or the annual percentage rate. They also profit from those who do not read their credit card statements and pay only the minimum payment required. The interest charges could get as high as matching the amount of the original purchase you made on each service or item.

We were not always a credit card carrying society. In fact, when one of the first credit cards was introduced such as the Diners Club Card, it was not considered a credit card. It was a charge card. This meant that you were supposed to pay off the balance in full every single month. Other charge cards that followed were American Express and the Bank America Card. The consumer had the advantage of using the bank’s money for a short window of time which allowed them to plan financially to pay for the upcoming bill.

Around the late 1980’s, companies such as Discover, MasterCard and Visa were issuing credit cards where consumers can hold balances and a specific interest on the amount. Today, most retail outlets are branding their company with credit cards. They are enticing customers to apply so that they can get 10% to 15% off of their first purchases. Over time, Americans have found themselves with a wallet full of major banks and retail credit cards. It’s no wonder we cannot keep up with the interest.

Let’s get you empowered and start by explaining some of the most common terms of a credit card statement. Once you know and understand these terms, shopping for a credit card will be easier. You will also know what questions to ask a banking institution before you apply for credit as well. You will also find yourself making informed decisions when considering a major purchase and saving yourself a lot of money in the long term.

Let’s start with some terminology.

 

Annual Percentage Rate (APR)

When applying for a credit card, there is a stated interest rate at the time you apply. The interest rate is based on the prime rate which is two points above the federal interest rate. The interest rate can be fixed or variable. The fixed rate does not change. On the other hand, a variable interest rate is subject to change. The Card Act of 2009 requires banks to notify consumers when interest rates are raised.

The APR is the stated amount of interest you pay when you carry a balance from the end of your closing date to the next billing period. The interest begins to calculate from the date of your purchase. If at the end of the billing cycle you have $1000.00 balance, you will pay interest on that amount. You are not charged this APR annually. You are charged daily by dividing the APR by 365 days. The amount of days per year varies from bank to bank. Some banks use 360 days, while other use 365 days. This calculation gives you the periodic interest rate or the daily periodic rate.

Here’s an example for a $1000.00 credit balance:

15.00% APR / 365 = 0.041 (daily periodic rate)

 

Daily Periodic Rate

The amount of interest charged daily based on the current balance. This could look like a small amount but it adds up.

 

Average Daily Balance

Your balance changes throughout the billing cycle month because you may decide to make a few payments during the billing cycle. Let’s say you made a few first purchases on your new credit card that added to $1000.00. The billing cycle started on the 3rd and ends on the 2nd of every month which accounts for 30 days. From your paycheck, you decide to pay $300.00 on the 16th day and make another $300.00 payment on the 26th day. Take a look at the following calculation using the 15% APR:

(15 x 1000.00 + 10 x 600 + 10 x 400)/30 = $833 (Average Daily Balance)

You will see that there were 15 days of interest to be charged on your purchases. Because you paid a total of $600 dollars by the next 10 days, you have a remaining balance of $400.00.

In order to determine the amount of interest you will owe for the next month, you have to multiply the average daily balance by the daily periodic rate. Finally, you will multiply by the number of days in the billing cycle, which is normally 30 days.

$833 x 0.041% x 30 = $10.24 (Amount of interest you owe)

The amount of interest you owe fluctuates every month. It depends on your use of the card and the amount of payments you make. When you review your statement, you are going to see the beginning balance, payments made, new charges, fees (if any) and finally, the interest or finance charge. Some banks use the term finance charge and others use the word interest charge. 

Beginning balance: $1000.00

Payments made: $600.00

Interest charge: $10.24

Credit balance: $410.24

This is an ideal scenario for someone who is paying quite a bit toward the principal balance. Paying a significant amount pays the balance off quicker and reduces the interest amount based on how soon the payments are made within the month. However, this scenario works well when you are not making additional charges that would exceed the payments made.

Here is an example of how credit card interest applies when making some payments on a credit card every month. The numbers are taken from a real credit card statement.

 

Month One

Month Two

Month Three

Previous Balance

$5,935.29

$6497.57

$7127.93

Payments and credits

$1312.17

$300

$667.16

New charges

$1794.67

$836.68

$514.59

Interest charged

$79.78

$93.68

$86.70

New balance

$6,497.57

$7127.93

$7,062.06

Minimum payment

$156.00

$164.00

$156.00

 

Notice how the interest amounts fluctuate from month to month. This scenario should help you understand how paying the minimum amount will not have any effect on the balance. This is why most people get into deep debt very quickly. On the other hand, you will notice that a significant payment was made between Month One and Month Two, but the balance has increased.

There is another advantage to understanding the calculation of your interest rate. You will also be able read your statements more carefully. As a result, you will not miss any unauthorized charges or billing errors that can occur. Some consumers can be charged twice for a purchase or not have their payments posted. Get in the habit of reading your statement thoroughly so that if there are any mistakes, you can report them early. Most banks have statutes on when an error must be reported.

There are some references and tools you can use to help you plan to pay off your credit cards and to find cards with low interest rates.

1. Credit Card Payoff Calculator

2. Debt Repayment Calculator

3. Dept Payoff Calculator

 

The Card Act of 2009

The Credit Card Accountability Responsibility Disclosure (CARD) Act was signed into law in 2009 by President Obama. This was designed to establish fair practices when extending credit to consumers. This act requires banks to include a section on their statements showing the calculation of how long it will take to pay off your balance if you paid the minimum amount. Credit card companies such as American Express will give you other higher amounts than the minimum for comparison purposes. This helps the consumer realize how long it takes to pay off a credit card balance by making only minimum payments. Therefore, they are encouraged to pay more than the minimum.

The Act is a benefit to consumers because they are notified at least 45 days in advance when their interest rates are going to change or if there will be an annual card fee increase. The cardholder will also be able to receive their monthly bill 21 days earlier from the due date. The biggest advantage is that for a new account, interest rates have to remain unchanged for the first year.

Now that you are an informed consumer, you will be able to use your credit card effectively. Understanding how interest is calculated is a powerful tool in helping you make important financial decisions. You may decide that paying credit card interest is not worth it, so you make small manageable purchases which will enable you to pay off your bill every month. If you do decide to pay interest by leaving a balance, you are equipped with knowing how much that real purchase cost you with the added interest.

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