What is credit card interest and why does it matter?
Interest is the amount of money you’ll pay your credit card issuer if you don’t pay the entire balance by the date shown on your credit card statement. So even though your bill will show that you only need to pay a minimum amount, you have to pay the total amount to avoid interest charges altogether.
The amount of interest a credit card charges is typically displayed in the user agreement when you sign up and when you log in to your online banking account.
Every credit card has an interest-free period. This timeframe lasts at least 21 days, but it can be longer depending on the card. Knowing how credit card interest works is vital since it’ll determine your overall carrying costs. If you abuse your credit cards and miss payments, you could quickly fall into debt, which also impacts your overall credit score.
Read more: Best low-interest rate credit cards in Canada
Types of credit card interest rates
Many people forget that there are different types of credit card interest rates. How you use your card will determine what the interest rates are. The following are the most common types of credit card interest rates:
Purchase interest rate
When looking at your credit card statement, you’ll notice that your interest rate is listed as an annual percentage rate—known as the APR. The APR is the most common type of credit card interest. It’s what you’ll pay on your purchases, and it typically ranges between 20% and 22%. You won’t be charged any interest as long as you pay your bills in full and on time.
Cash advance interest rate
Just about every card allows you to make a cash advance. This is where you can use your credit card to withdraw money directly from an ATM. However, most credit cards charge a few percentage points more than the APR for this service. For example, it’s common to see a credit card that charges 19.99% interest APR, and 22.99% for cash advances.
Besides the interest rate, the significant difference between cash advance interest rates and the APR is the grace period. With cash advances, you start accumulating interest right away. Additionally, purchases such as lottery tickets, gambling sites, and wire transfers are considered cash advances.
Balance transfer interest rate
When applying for a new credit card, some cards will allow you to balance transfer what you owe on an existing card to your new one. In addition, the balance transfer rate you’re offered can often be quite good. For example, your new card might provide you with 0% interest for 12 months when you transfer your balance.
This balance transfer interest rate is offered as an incentive to sign up. However, a fee based on the sum you’re transferring may apply. For example, the balance transfer fee could be 1%. Although that amount will be added to your credit card balance, the overall savings you get with the transfer could be worth it.
Read more: The best balance transfer credit cards in Canada
Penalty interest rate
Although it’s clearly outlined in the cardholder agreement, many people fail to read about the penalty interest rate. Basically, most credit card companies can increase your interest rate if you miss two payments. These two payments don’t need to be consecutive. They could be over the course of a few months or even years. The increase in your interest rate can quickly go up by 5% to 10%.
How to calculate credit card interest charges?
To find out how you’re being charged, you need to look at your cardholder agreement. However, keep in mind that different financial institutions have different methods to calculate credit card interest.
Generally speaking, the following three steps will outline how to calculate credit card interest charges.
Step 1: Figure out your daily interest rate
Even though APR stands for annual percentage rate, the interest itself is calculated daily, so you first need to convert your APR to the daily interest rate.
This is pretty simple math: All you’re doing is taking your interest rate and then dividing it by 365—or 366 if it happens to be a leap year. Some banks use a calendar of 360 days to keep things consistent. The difference in interest over a few days is pretty minimal, so don’t overthink it.
Either way, the number you get is your daily interest rate. For example, let’s say your credit card provider uses 365 days to calculate the APR on your credit card that charges 19.99% interest. That means your daily interest rate is .0547%
Step 2: Take a look at your daily balance
This part gets a bit more complicated. First, take a look at your statement and see what your billing period is. How much interest you’re charged is based on the average daily balance.
To calculate that rate, you need to factor in any amounts carried over from the previous month. Any payments you’ve made should be subtracted from the balance. Now add up each day’s balance. Once you have the total sum, divide it by the number of days in your billing period. For example, if your balance is $2,000 and your billing period is 28 days, then your average daily balance is $71.43.
Step 3: Add it all up
Finally, multiply your daily interest rate by your average daily balance. Now, take that number and multiply it by the number of days in your billing cycle. That’s the amount of interest you owe.
If you’re math-averse, don’t worry: There’s no reason to calculate your interest manually. Your credit card statement will list the interest (and total amount) owed. And even if you followed this guide to calculate how much you owe, your calculation may differ slightly from your bill depending on if your bank compounds interest daily or monthly.
How to save on credit card interest
While you can’t lower your interest rate, there are a few things you can do to lower your costs. Here’s how to save on credit card interest:
- Pay your bills in full and on time: You won’t need to worry about any interest charges if there’s no balance. Just pay off your full bill before the due date.
- Get a low-interest credit card: Credit cards are available with an interest rate between 8%-16%. This is a considerably lower interest rate than the average of 20%-22%.
- Balance transfer: If you’re carrying a balance, it can make good financial sense to do a balance transfer to a card with a promotional period interest rate.
- Make more than the minimum payment: If you must carry a balance, try to pay more than the minimum balance. Then, you won’t be charged as much interest as you’ll still be making a partial payment.
- Use a prepaid credit card– If you’re worried about interest payments, you could use a prepaid credit card instead. With these cards, you can only spend the funds you’ve already deposited.
Read more: Best prepaid credit cards in Canada
The last word
Having a grasp of what is credit card interest and why it matters is essential, but it’s unlikely to be the only reason you apply for a credit card.
For borrowers who are currently carrying a balance, then the APR has a direct effect on them. Switching to a card with a balance transfer promotion or a low-interest credit card can help you pay off your credit card debt more quickly.
While credit card interest rates are important, it really depends on your individual situation. For example, someone who always pays their bills in full and on time shouldn’t care about interest rates since they’ll never be paying them. Instead, they should focus on the welcome bonus, earn rate, and any additional benefits that come with the card.
For borrowers who find themselves carrying a balance, the solutions above should help minimize, and eventually, completely pay down their debt.
Read more: Simple steps to get out of credit card debt in Canada