How Does Credit Card Interest Work?

How Does Credit Card Interest Work?
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It would be great if you could just swipe your credit card to make a purchase then hand over the exact amount of the purchase to the company a little later when you have the cash. Unfortunately, it doesn’t work that way. Credit card companies are in business to make money, and they do it by charging you interest on your purchases. That hasn’t stopped many people from using their cards, however. The Center for Microeconomic Data indicates that household debt in the U.S. reached an all-time high in 2017, and balances on credit cards went up more than 3 percent.

How Does Credit Card Interest Work?

Credit card companies calculate and charge interest according to an annual percentage rate, or APR, but this rate isn’t the same for all cardholders. Those with superior credit usually pay a lesser rate. And different types of charges can incur different rates. It will often cost you more to take a cash advance rather than simply charging a purchase.

Don’t let the “annual” part of the term fool you either. This doesn’t mean you’ll only pay interest once a year. Credit card companies use your APR to calculate interest on your account based on your average daily balance. If you divide your APR – which should appear on your credit card statement – by 365 for the number of days in the year, you can determine how much interest you’ll pay that day if you multiply the result by your balance on that date. The total amount of interest you’re being charged per billing cycle should appear on your statement.

And yes, the daily balance used to calculate all this includes interest that was charged to your account previously. You’re paying interest on interest. This is called “compounding.”

What Happens If You Pay the Minimum on Your Credit Card Each Month?

Most credit card lenders charge minimum monthly payments equal to about 2 percent of your balance at the close of the billing cycle. But making just this minimum payment on your credit card each month while still charging can bury you in debt.

Remember, that interest is compounding. And even if you stop charging or your balance reaches your credit limit so you can’t charge anymore, you’ll be paying it off for a very long time if you’re just making just those 2-percent payments. You’re essentially just treading water. You’re not making any headway because more interest is being added every month.

By the same token, you don’t ever want to skip making that minimum payment because it’s what’s keeping your account in good standing even if your balance is high. Your credit score depends on it – and a good credit score will earn you lower interest rates on new accounts going forward.

What Are the Disadvantages of Using a Credit Card?

There’s a good reason why credit card balances are increasing – credit cards can be the epitome of convenience. But they’re not without their disadvantages. In addition to racking up interest charges each billing cycle, you risk tanking your credit score if you don’t handle your credit card accounts just right.

How much of your credit limit you’ve actually used is an important factor in calculating your credit score. It’s called your credit utilization ratio. If you have a single card with a $5,000 limit and you’re hovering at about a $4,000 balance month after month because you’re only making minimum payments, your credit utilization ratio is 80 percent. That’s very high. It’s recommended that consumers try not to go over 30 percent and about 10 percent is much better.

Handling your cards correctly can often mean triumphing over human nature. It’s easier to spend – sometimes on things you don’t really need – when you’re not plucking dollars out of your wallet and actually handing over your hard-earned cash. And if you do this often enough while making only minimum payments on your credit card balance, your credit utilization ratio will keep creeping up.

Is It Good to Have a Balance on Your Credit Card?

It can be good to have at least some balance on your card; so don’t take your scissors to that plastic just yet. Just as mismanagement of your account can drag your credit score down, responsible handling of an account can maintain your score and even push it upward.

Yes, this means paying as much as you possibly can each month and keeping that balance under control. By the same token, you probably don’t want to pay the card off entirely and sit on a zero balance indefinitely either. Credit card lenders have been known to close accounts due to inactivity and this can hurt your credit utilization ratio, too. It reduces the total amount of credit available to you so your other existing balances eat up a greater percentage.

Ideally, you should keep your credit utilization on each available card at 10 percent or less. This means making small charges periodically and maintaining a manageable balance.

How Do You Avoid Paying Interest on a Credit Card?

Making small charges and then paying your credit card balance off in full every month is probably the ideal scenario. You’re using the card so the lender isn’t likely to close the account. You’re keeping your credit utilization ratio near zero, which helps your credit score. And you might even be able to dodge paying interest.

Some credit card lenders offer “grace periods” from interest. Maybe you’ve charged $100 this month. Your statement is dated May 21, the last day of the billing cycle. The due date on the bill is June 1. You won’t be charged any interest if you pay that $100 in full any time between May 21 and June 1. Otherwise, any balance that remains after you make your payment will begin accruing interest. These grace periods usually amount to about 21 days.

Having credit cards – even several of them – doesn’t have to spell doom. It’s all about understanding how they work and making them work to your advantage.