How Does Credit Card Interest Work

Why do credit cards charge interest?

A credit card performs two essential functions. First, it's a method of payment that you can use instead of other forms of payment, such as cash or checks. In fact, it's one of the most secure, reliable, and convenient methods of payment that you can use in-person, over the phone, and online.

While it seems like credit cards work the same as debit cards, a credit card account gives you a line of credit you can use to finance purchases over time. To put it another way, every time you purchase with a credit card, you take out debt or loan from the credit card issuer.

The card issuer, typically a bank or a credit union, is taking a risk that you will be willing and able to pay back that loan or debt on time. And while the vast majority of credit card users make their payments on time, a significant number will pay late or never at all.

To make up for the risk of late payment or no payment at all, the card issuer will charge interest on the cardholder's purchases. The interest compensates the card issuer for the risk of making loans to people. It also allows these institutions to earn more interest than they would have by simply investing their money instead of loaning it out.

In addition, credit card interest charges pay in part for card issuers' administrative costs, the cost of credit card rewards and benefits, as well as the cost of making and mailing the cards themselves.

How do credit card interest rates work?

The credit card interest rate is measured as an annual percentage rate or APR. This simple number is based on the percentage that could be paid out over a year. Measuring credit card interest by APR also offers a standard to compare the rates of different cards.

However, the APR alone doesn't tell you the whole story. Credit card interest rates are applied based on the account's average daily balance during your statement period. The credit card company converts the credit card APR to a daily interest rate by dividing it by 365, the number of days in a year.

For example, imagine your credit card account has an average daily balance of $1,000 and an APR of 20%. Your APR divided by 365 is .0548%, and the interest incurred that day is 55 cents.

However, most credit card issuers will add the new interest charges to your balance each day, a process called compounding. So tomorrow, your interest charges will be calculated based on a balance of $1,000.55, and the interest charged will be calculated on that. But you'll only see the new interest charges on your statement, not every day.

If you are wondering, “is credit card interest tax deductible,” the answer is no. However, it may be if the credit card loan is for a business activity, depending on the situation.

How is a credit card's interest rate determined?

A credit card company or issuer chooses rates for each type of card or product, and with many credit cards, there won't be a single rate. Instead, many cards will offer a range of rates or multiple rates. The rate you receive will be based on your creditworthiness at the time you applied.

So, wondering how to lower your credit card interest rate? Those with an excellent credit score will receive the lowest available standard rate. In contrast, those with lower credit scores or bad credit history can expect to get a higher interest rate if they are approved at all.

And in addition to the standard interest rate for purchases, other rates can apply. For example, most credit cards have higher rates for a cash advance, and some have different rates for a credit card balance transfer.

Most cards also impose a much higher penalty interest rate when you fail to make your monthly payment on time. On the other hand, many credit cards offer new applicants 0% APR promotional financing for a limited time on new purchases, balance transfers, or both.

Also, most credit cards offer so-called variable rates that can fluctuate with the Prime Rate. The Prime Rate is the rate that banks charge their best customers, and it's based on the federal funds rate determined by the Federal Reserve Board.

So when the Federal Reserve Board raises or lowers their rate, the APR for credit cards with variable rates will rise or fall by the same amount.

Do you get charged interest if you make your minimum payment?

You can expect to incur interest charges on your average daily balance when making just your minimum payment. Furthermore, by making just the minimum payment, you're actually ensuring that your average daily balance remains as large as possible without being delinquent or in default.

So making just the minimum payment will mean that you'll owe more in interest than you would have if you had made a larger payment. So to save money on interest charges, always pay as much above the minimum amount as you can afford.

Is there any way to avoid credit card interest?

One of the great features of almost all credit cards is that you can avoid interest charges by paying your entire statement balance on time. Technically, you will still incur interest charges during your statement cycle, but nearly all credit cards offer a so-called grace period that allows you to have those charges waived when you pay your entire statement balance by the due date.

Suppose you fail to pay the entire statement balance, or your payment was late. In that case, you'll still have to pay interest charges on your average daily balance. These charges will appear on your following statement, along with any applicable late fee.

How to lower your credit card interest rate

There are several ways that you can lower your credit card's interest rate.

First, you can be sure to shop around for credit cards with the lowest interest rate. Invariably, the cards with the lowest rates will offer few features and benefits and no rewards.

If you're trying to get a lower rate from the card you have, you can try calling and asking for a lower rate. You are most likely to be successful if the card you have is offered with a range of interest rates, and the rate you have isn't among the lowest already. It helps to have a higher credit score than when you first applied, as well as a long record of on-time payments.

Another way to get a lower interest rate is to open a new account with a 0% APR promotional financing offer for balance transfers. These offers, which have to last at least six months, allow you to transfer your existing balance to the new account and avoid interest charges for the duration of the offer.

However, be aware that most of these offers have a 3% balance transfer fee added to the amount transferred. Some have fees of as much as 5%. Also, keep in mind that the standard interest rate will apply to the remaining balance when the promotional rate ends. And because these offers are designed to attract new customers, you won't be able to transfer a balance between two cards issued by the same bank or credit union.

Do all cards have the same interest rate?

Credit cards will offer different interest rates depending on the card issuer, the type of card, and the account holder's creditworthiness.

The average credit card in the United States has a standard interest rate for purchases of about 15%.

Credit cards that offer rewards and the most valuable benefits typically have higher interest rates, as do cards designed for people without excellent credit.

The credit cards with the lowest interest rates will be simple cards designed for those with an excellent credit report. These cards won't offer any reward points or miles and no cashback.

And often, the cards with the lowest interest rates are offered by credit unions. Unlike banks, credit unions exist to provide services to their members rather than profits to their shareholders. Since they don't have to maximize profits, some credit unions offer credit cards with an exceptionally low interest rate.

Bottom line

The most important thing to remember from this article is how to minimize the amount of interest you are charged. Once you understand how credit card interest rates work, you can find the best card for your needs. A credit builder card may be a good option if you’re trying to improve your credit. Learn more about Self’s credit building programs today!

About the author

Jason Steele has been writing about credit cards and personal finance since 2008, poring through the terms and conditions of credit card agreements to understand the minutiae of how these products work. His work has appeared on Yahoo, MSN, HuffingtonPost and other major news outlets. In his free time, Jason’s a commercial pilot. He graduated from the University of Delaware with a degree in History. See Jason on Linkedin and Twitter.

About the reviewer

Lauren Bringle is an Accredited Financial Counselor® with Self Financial– a financial technology company with a mission to help people build credit and savings. See Lauren on Linkedin and Twitter.

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Our goal at Self is to provide readers with current and unbiased information on credit, financial health, and related topics. This content is based on research and other related articles from trusted sources. All content at Self is written by experienced contributors in the finance industry and reviewed by an accredited person(s).