Paying cash keeps you out of debt, but it's not always an option, especially for big-ticket items such as cars and plane tickets. That's where banks and credit card companies step in. They make money by charging interest and finance charges when they help fund your purchases. These two fees differ slightly, but both can increase the price of what you buy.
You pay interest as a fee for using the bank's or credit card company's money. Interest is calculated on any outstanding balance you carry. You can avoid paying interest by paying your credit card balance in full every month, as 56 percent of American cardholders do, according to Consumer Reports research. You can reduce the amount of interest you owe on a loan by paying it off early, although some contracts impose a pre-payment penalty.
Interest represents one component of the finance charges lenders impose on borrowers; sometimes it's your only finance charge. Other types of fees that fall under the term include annual fees for credit cards, late-payment fees, charges for exceeding your credit limit and transaction fees on cash advances. Some of these non-interest finance charges represent one-time expenses; for example, loan origination fees or points required for a mortgage.
Cost of Credit
The annual percentage rate describes your borrowing cost per year for any unpaid balance. Because APR on a loan includes more than the interest rate, it makes a good comparison tool when shopping for financing. APR amortizes, or spreads out, those non-interest finance charges across the life of a loan on top of the interest charge. Credit card APRs represent interest only because the card-issuer cannot predict what, if any, fees a cardholder may incur. If a credit card charges 2 percent each month on any unpaid balance, the APR for that card is 24 percent annually.
The lower your credit score, the higher the interest rate you'll pay. Miss or be late with a payment, and you'll probably see a higher APR on your monthly statement. The Credit Card Act, officially known as the Credit Card Accountability, Responsibility, and Disclosure Act, requires credit card providers to review APR increases twice a year, or every six months. The rate must be lowered within 45 days of this review when payment history merits it.
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