If you carry a balance on your credit card, you're not alone – but do you understand exactly how interest is calculated?
Your purchases get a lot more expensive when you don’t pay your balance in full. Learn how credit card interest works to understand how much you’re paying.
The Grace Period
First, some basic terminology – a credit card is not the same as a charge card, which requires that you pay your balance in full each month. Charge cards don't accrue interest, because you cannot carry a balance.
Most credit cards, on the other hand, have a grace period. The average is 28 days. This gives you 28 days to pay what you charged in full. If you do, there’s no interest. You only pay what you charged.
Now, if you miss a payment or only pay a portion of the balance, the credit card company charges interest daily on your balance. Every day you have a balance, it accrues interest using the daily rate, which is your annual APR divided by 365 – so if your interest rate is 19%, your daily APR is 0.052%. This may sound small, but it's calculated daily, so it will add up quickly.
The next day not only does your balance accrue interest, but so does the interest charged the previous day. This continues until you pay the bill in full.
How Credit Card Interest Works – An Example
Let’s look at how credit card interest works in an example.
You buy some furniture for $1,500 using your credit card. When your statement comes, the total balance is $1,500, but you decide to only pay $100, leaving a balance of $1,400. Your credit card has an interest rate of 19% (and therefore a daily rate of 0.052%), which accrues daily.
After 30 days, you’ll accrue $22.03 of interest, and your balance will have grown to $1,422.03. That’s just one month of interest. If you don’t pay the balance off in full in the first month, the balance will continue accruing daily until you pay it off.
If you continue paying $100 per month, it would take you 18 months to pay it off, and cost an additional $219 in interest – which means the total cost of your furniture was $1,719.
Now let’s say you only made the minimum payment required on the $1,500 purchase. Many credit cards charge an additional 1% fee of the balance plus interest if you only make the minimum payment. WIth an additional $15 minimum payment fee, your $1,500 charge would cost you $37.03.
Only Charge What You Can Pay Off
Knowing how credit card interest works may help you understand the importance of charging only what you can afford. If you have an emergency and need the card, use it, but do what you can to pay the balance off as fast as possible, and try to pay more than the minimum.
Falling for the minimum required payment leaves you with hundreds or thousands of dollars in interest and debt that lasts for many years. If you have credit card debt, consider consolidating it or transferring it to a 0% APR credit card. Pay your balance down as much as you can on the credit card to avoid future interest charges and avoid using your credit cards when it’s unnecessary.