How Does Credit Card Interest Work?
If you have ever carried a balance on a credit card, you have probably asked yourself how does credit card interest work?
The basics are pretty simple: You borrow money from a credit card company, and if you do not pay it back practically right away, you are charged interest on the outstanding balance. However, how exactly is this interest charged, and how much could it cost you?
Most people are unaware that credit card companies charge interest daily, not monthly. Interest compounds each day, and you cannot pay down the principal until you clear the accrued interest. So starts the debt cycle.
How credit card interest is calculated
The average interest rate on a credit card is 19.99%, but many cards can be as high as 29.99%.
Interest is shown as an annual percentage rate (APR), which is a fee we pay for borrowing money we do not have. Credit cards allow you to pay for something today that you would otherwise have to save for, and they are an extremely convenient way to spend money.
Credit cards charge interest daily, not monthly
Credit card companies rely on the fact most people do not understand how interest compounds on their credit cards.
Compound interest means interest is being charged on top of interest. With a cycle such as this, the debt can quickly grow exponentially.
Here is an example of how compound interest impacts what you pay back.
You have a $5000 balance on your credit card, and the APR is 19%
This means the daily interest rate is 0.052% (19%/365 days)
Multiply $5000 by 0.052%, and you get $2.60. This means the first day of interest you are charged $2.60. You say to yourself “that’s not too bad.”
Well, on the second day your balance is now $5002.60, so you pay 0.052% on the new balance of $5002.60, and so on and so on.
Now, it’s not all bad. Credit card companies allow you a ‘grace period’, during which you can pay back the borrowed amount with zero interest charges.
The grace period is usually between 21 and 30 days, but it’s different for each credit card and company.
Credit card companies rely on the fact many people do not have the financial capacity to pay back the entire amount borrowed within the grace period.
What if you only make the minimum payment?
The minimum payment is the smallest amount you can pay back each month without going into default and incurring late fees.
Your minimum payment is applied towards that month’s interest charges, and any leftover (which is minuscule if you’re only making the minimum payment) will be applied to the principal balance.
Making minimum payments will keep the card in good standing, but it will make the cost of the purchase so much more expensive.
Regulation has forced credit card companies to include a warning showing how long it would take to pay off the balance if you only made the minimum payment. See below.
As you can see, it is important to pay off high-interest revolving debt as soon as possible to keep your finances healthy!