If you’re carrying a balance on your credit card, even a small one, you’re paying interest. But if you understand how credit card interest works, you can avoid the most common pitfalls and behaviors that get many borrowers into financial trouble.
Simply put, your credit card’s APR (annual percentage rate) is either a fixed or variable the rate a lender charges you to borrow money over a one-year period. A fixed APR is set by your lender and does not fluctuate with the market. There are certain circumstances that can still cause a fixed APR to rise—such as being over 60 days late on a credit card payment or reaching the end of a promotional rate—but in general it stays the same throughout the life of your card.
A variable APR, on the other hand, is tied to an industry index such as the Wall Street Journal Prime Rate and is subject to the fluctuations of the market. Lenders nationwide use the prime rate as a benchmark for determining the range of variable APRs they’ll offer borrowers. Typically, banks and lenders start with the prime rate as the base rate, then add a margin in order to profit from the loan.
With both fixed and variable APRs, the best rates are offered to borrowers with good-to-excellent credit. The better your credit, the less you’ll wind up paying in interest fees if you habitually carry a balance.
How to calculate interest on a credit card
Although your APR is a measure of your annual interest rate, your interest is actually charged on a daily basis as your “daily periodic rate.” Why is this important? Because it means that when it comes to your interest charges, every day counts.
You can use your daily periodic rate to calculate just how much these daily interest charges are costing you. To get your daily periodic rate, divide your APR by the number of days in a year (365). For example, if your APR is 20%, you’d divide 0.20 by 365 to get .00054%. Next, multiply your daily periodic rate by your credit card balance at the end of any given day. Say your end balance is $1,500. You’d multiply that number by .00054% to get $0.82. So with a 20% APR and an average daily balance of $1,500, you’re paying $0.82 in interest every single day.
Did your daily interest charges come as an unpleasant surprise? If so, you’re not alone. It can be quite sobering to realize how much you’re paying in interest fees, but it can also serve as a wake up call. If your daily interest charges just gave you sticker shock, now is a good a time to start developing healthier credit card habits. We’ll let you in on a few tricks that can help you along the way.
Grace periods and bi-monthly payments: Your secret weapons
For the savviest of credit card users, APRs are a non-issue. This is because they take advantage of what’s known as the “grace period.” “The grace period is the gap between the end of your credit card’s billing cycle and the date your payment is due,” says Deb Hipp, a financial writer for Credit Karma. “With most credit cards, if you pay your balance in full and have no cash advances outstanding, you won’t be charged interest on new purchases you make during this interval.” Most credit cards offer a grace period of 21-days, but check your cardholder agreement to make sure your card issuer offers one. Some issuers offer shorter periods, and some don’t offer them at all.
Of course, taking advantage of your credit card’s grace period only works if you pay off your balance each month. If you tend to carry a balance, here’s another trick to help you pay down your debt faster: bi-weekly payments. There are some key advantages to making a payment toward your credit card every two weeks instead of only on your monthly due date. For starters, you’re sneaking in an extra payment each year. Since there are 52 weeks in a year, you’re making 26 half-payments, or 13 full payments. That’s one more payment per year than the 12 you make when you only pay on your due date.
Another advantage is that it lowers your average daily credit card balance, which we’ve already learned has a huge impact on your daily interest rate. The lower your daily balance, the lower your interest fees.
And finally, bi-weekly payments can help even out your cash flow. “[C]ash flow isn’t always steady, and extra cash is either hard to find or too easy to throw towards unnecessary purchases,” says financial writer and blogger Kayla Albert. “By stabilizing your bill payments and keeping expenditures the same for each paycheck, you can get a better grasp on exactly where your money is going and how much is actually expendable (if any).”
One more thing
Forget the so-called common wisdom that you need to carry a balance in order to build credit—it’s a myth. If you can’t pay off your entire balance each month, try to pay as much as you can above the minimum balance so you can reduce the overall balance you’re paying interest on. If you’re only paying the minimum balance, you’re basically paying interest and a tiny amount of your balance. Of course, it’s always better to pay the minimum amount rather than skip a payment altogether. Missed payments lead to late fees and can cause major damage to your credit score.