A Smart Guide: Understanding Credit Card Interest

Credit card statements can be confusing, but they don’t have to be.

Here’s what it all really means and how to determine the real cost of your credit card.

First, you need a basic understanding of what interest is. It’s a fee that you pay for getting to borrow money. When dealing with credit cards, interest is money that you must pay in addition to the cost of the goods or services you purchased using your credit card. The amount of interest varies and is expressed as a rate, which is a percentage of your overall expenses paid for with the card. If you pay off your credit card bill in full every month, you won’t owe any interest, no matter what your interest rate. If you don’t, the interest is charged on whatever is left – called a balance – after you make the minimum payment required by the credit card company.
Credit card interest is most often defined as an APR or annual percentage rate. That is the yearly rate of interest charged on purchases you make using your card. But the APR can change, depending on your type of card:

  • Variable Rate: The APR on these cards is pegged to a reference rate (usually U.S. Prime) and routinely moves up and down in relation to that rate.
  • Non-Variable Rate: The APR on these cards is set by the credit card company and is not tied to outside rates. It can still be changed by the company, but they have to notify you first.

Some cards hook you with a low APR for just a set period of time, and then the rate shoots up. Pay close attention to the terms of cards offering these introductory “promotional” rates.

Despite knowing what your APR is, what you actually pay in interest each month can be more, thanks to your Daily Periodic Rate, which is calculated by dividing your APR by days in the year: 365. Then that number is multiplied by your average daily account balance (determined by averaging your unpaid balance over the course of the month) and the days in the specific month. The resulting number is the interest rate you are charged that month.

Keep in mind that this daily periodic rate compounds every day, so the longer you wait to pay off your balance, the more the interest adds up. By paying just a little more than the required monthly minimum, you can reduce your chance of ending up in major credit card debt.