How Does Credit Card Interest Work?

Credit Cards
Credit Cards

Banks and credit card companies will put interest on their loaning products to make money. That money offers cardholders a solid incentive to pay off their balance off by the end of the month.

However, the amount of interest you pay can change depending on the card you have, the balance left on your card, the transactions you make, and when you make repayments.

What is Credit Card Interest?

Interest is what credit card companies charge you for borrowing money. This is usually expressed as an annual percentage rate. Most credit cards will have a fluctuating APR that changes when you hit a benchmark, such as prime rate.

The prime rate is what a bank will offer to its most creditworthy customers, which is why it pays to have good credit.

Let’s say the prime rate is 5%, but credit card companies will charge a prime rate plus 17%. This means your interest rate will be 21%.

While that seems high, and it is, banks will only charge you interest if you don’t pay off your balance by the end of the month.

How do Credit Card Companies Calculate Interest?

The way your credit card interest is calculated varies depending on who you bank with. For example, if you live in Australia and you were to make a credit card comparison with iSelect, you’ll notice that several of their cards offer an interest-free period for up to 55 days.

Then, the interest rate reverts to 18.99%, which is standard for most credit card companies.

However, most credit card companies won’t give you an interest-free period upon sign-up and will begin calculating interest the moment you make a purchase.

Interest stops accumulating once you pay your balance in full. Interest rates are calculated differently for the following:

  • Purchases: Typically have the lowest interest rate.
  • Cash Advances: Usually higher than purchase interest rate by 2-5%.
  • Balance Transfers: Uses a similar interest rate to a cash advance.
  • Overseas Spending: Often a very low-interest rate of 3-5%.

Credit card companies will average the balances over the statement period, multiply the average balance by applicable daily interest, then multiply that amount by the number of days in a statement period. Basically, the higher your credit card balance, the more interest you’ll pay.

Why It’s Important to Pay Your Balance in Full

Credit cards shouldn’t be treated as free money. Without the right attitude, you could accumulate more interest than what you can pay back, which will land you into significant financial trouble. On top of that, missed payments and debt can affect your credit score.

Most banks consider a “Good” credit score to be anything from 660-724. A Very Good credit score ranges from 725-759, and anything higher than 759 is “Excellent.”

When you keep your credit score high, you’ll gain access to lower interest rates, better lending products, and the possibility to own a more expensive home or car that would have been previously out of reach.

While making frequent credit card payments builds credit, you’ll quickly lose what you earned if you can’t pay your minimum monthly payments. So, when you have some cash to spare, it’s always better to pay off your balance and stop paying credit card interest altogether. 

If you’re having trouble paying off your credit card balance, you can transfer your balance towards another lending product, like a loan that has a lower interest rate. This way, you can keep paying off what you owe without destroying your credit when you file for bankruptcy.

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