Understanding How Credit Card Interest Works
One of the many ways credit card issuers make money is by charging you interest when you carry a balance on your card.
In a twist absolutely everyone expected, credit card interest is not at all straightforward. Cue a “Home Alone”–style shocked face. The rate you’re advertised isn’t quite what’s used to actually charge you, and when you’re charged can significantly impact how much you owe. Oh, and interest rates can change pretty easily and frequently after you sign up for a card.
Strap in. Here’s everything you need to know about how credit card interest works.
How Does Credit Card Interest Work?
Credit card interest is the amount of money you’re charged on top of your credit card balance when you repay later than the due date for that balance.
Anytime you use your card to make a purchase, withdraw cash or transfer a balance from another card, you incur credit card debt, but you’re not automatically charged interest. You’ll get a monthly statement with the amount of debt you’re carrying and a due date for repayment, usually a month out. If you repay the debt balance by the due date, you won’t pay interest on it. For each day past the due date that you carry any balance, you’re charged interest at the unique rate you were offered in your card agreement.
An interest charge is effectively an addition to your card balance. The card issuer adds a percentage of your balance (the credit card’s interest rate) to your debt total each day, increasing the total you owe. As you pay down the balance (whether that’s all at once or in increments), the amount added in interest gets smaller, and you pay no interest on a $0 balance.
You’ll never owe interest on any charges you repay before the statement due date. But you do owe interest on any balance you carry past the due date, even if you make the minimum payment listed on your credit card bill. (The minimum payment gets you out of owing late fees, not interest.)
How Is Credit Card Interest Calculated?
Credit card interest is calculated based on your credit card balance and your interest rate and generally charged daily.
You’ll always see your interest rate expressed as an annual percentage rate (APR). The percentage companies use most often to calculate credit card interest is actually a daily or monthly periodic rate, but the U.S. Truth in Lending Act requires issuers to disclose the APR to ensure consistency across credit card companies. APR is the daily periodic rate multiplied by 365 or the monthly periodic rate multiplied by 12.
Interest gets calculated using your balance on a given month or your average daily balance for a given month. This only applies if you’re carrying a balance; if you carry a $0 balance, you have until the due date to repay charges within a statement period without incurring interest.
Multiply the periodic rate by your balance to find the amount of interest you’re charged.
Here’s an example:
Say your credit card APR is 23.5%. That’s based on a daily periodic rate of 0.06437%. You started the month with a balance of $1,000, then made a purchase for $250 on the 10th and another for $250 on the 20th. So you carried a balance of $1,000 for 10 days, a balance of $1,250 for 10 days and a balance of $1,500 for 10 days. Find the average daily balance like this:
((1,000 x 10) + (1,250 x 10) + (1,500 x 10)) / 30
That’s an average daily balance of $1,250 with a daily periodic interest charge of $0.80. Applied over 30 days in the cycle, that’s an interest charge of $24 for the month.
When Is Credit Card Interest Charged?
Credit card interest is charged daily or monthly on any balance you carry on the card. You don’t pay interest if you have a $0 balance and repay any charges before the due date.
When credit card interest is charged is important because of compounding interest. As you can see in the example above, the interest you incur in one compounding period — each day or each month — increases your balance, and the interest in the next period is applied to that entire new balance. So you’re charged interest on the charges you put on the card plus the interest you incur.
In simple terms: Interest on interest on interest — it can add up quickly.
How much interest you pay can depend a lot on when interest compounds. A 1% increase in your balance each day is quite different from a 1% increase on your balance each month. That’s why your credit card interest rate is always expressed as an APR — so you can compare rates on cards quickly without confusion.
Your APR doesn’t tell you exactly how much interest you’ll be charged, though, because that depends on your balance at the time it compounds. If your interest compounds monthly, for example, you’re charged based on your total balance at the end of the month. But if it compounds daily, you’re charged based on your average daily balance, which could be lower if you make purchases or payments throughout the month.
Here’s more math to show you how that works:
Let’s return to your credit card with the APR of 23.5% and your balance of $1,500. With daily compounding interest, you’ll be charged $24 based on an average daily balance of $1,250.
With monthly compounding interest on the same APR, your monthly periodic rate would be 1.96%, and you’d be charged that rate once on your balance at the end of the period for a charge of $29.40.
How to Avoid or Reduce Credit Card Interest
To avoid or reduce credit card interest, you can pay off your balance in full, reduce your balance as much as possible or get a lower interest rate.
To avoid credit card interest altogether, you need to pay off your balance in full by the due date each month. If you don’t carry a balance, you won’t be charged interest.
To reduce how much interest you pay, pay off as much of your balance as you can each month. The lower balance you carry, the less you’ll be charged in interest, because interest is levied as a percentage of that balance.
You’ll also pay less in interest if you have a lower APR. The interest rate a credit card company offers you is often based on your credit score and payment history — the higher your score, the lower your rate. As your credit score improves, contact your credit card issuer to ask for a lower rate, and look for pre-qualified offers from other creditors willing to offer you a lower rate.
If you move credit cards to get a lower interest rate, find a card with a balance transfer option. That’ll let you move any balance you carry on the old card over to the new card, so you incur interest at the lower rate.
Types of Credit Card Interest Rates
Credit cards come with several interest rates that depend on where the balance comes from. Your card agreement will list the rate for each type of balance. Types of interest rates include:
- Purchase APR: The most common rate, purchase APR is the rate charged on things you buy with the credit card.
- Cash advance APR: This rate is charged on money you withdraw as cash using the credit card.
- Balance transfer APR: This rate is charged on balance transfers, money you move from an old card to this one.
- Penalty APR: The card issuer might raise your interest rate for around six months if you frequently miss payments.
- Promotional rates: Some cards come with a promotional period when you’re charged a lower APR, as low as 0%, for a period of six to 24 months. Any balance you carry past the promotional period will accrue interest at your regular interest rate.
Interest rates can be either fixed or variable. Here’s the difference:
- Fixed rate: This rate is set based on your credit score and payment history. As those factors change, a card issuer can change your rate after the first year as long as they give you 45 days’ notice, per the Credit CARD Act of 2009. Fixed rates are rare for credit cards since that law took effect.
- Variable rate: A variable rate is based on your credit score and payment history but is also tied to the prime rate — the base rate banks use to set interest rates, based on the Federal Funds rate. This type of APR can change anytime the prime rate changes, as well as fluctuate with your individual factors. Almost all credit cards have moved to variable rates since 2009.
Average Credit Card Interest Rates
In the U.S. the average credit card interest rate across all accounts was 16.27% as of August 2022, according to the Federal Reserve’s October Consumer Credit report. Average interest for accounts assessed interest (those that carried a balance) was 18.43%. Those averages have been steadily climbing over the past few years, as has the prime rate.
Frequently Asked Questions (FAQs) About Interest Rates
Here are answers to some of the most commonly asked questions about interest rates.
The best place to find your credit card’s APR is on your most recent statement, which you can access in your account through the card issuer’s app or website. You can always see your original APR in your credit card agreement, but it might have changed since you signed up.
If you carry a balance on your credit card, you’ll be charged interest based on your APR and the card’s compounding period. As long as you make the minimum payments listed on your credit card statements, you won’t be charged late fees, but you’ll continue to accrue interest on your outstanding balance. A balance on your credit card also means you have less available credit to use out of your credit limit, which limits your purchasing power and can affect your credit score.
On a credit card, there’s no real difference between interest rate and APR (annual percentage rate). Technically, an interest rate could refer to the daily or monthly periodic rate rather than the APR, but it’s safe to say that when someone refers to a credit card interest rate, they’re referring to the APR. (This isn’t true for mortgages and other installment loans, which include fees in the APR that aren’t included in the interest rate.)
Contributor Dana Miranda is a Certified Educator in Personal Finance® who has written about work and money for publications including Forbes, The New York Times, CNBC, Insider, NextAdvisor and Inc. Magazine.