When you use a credit card, you are essentially borrowing money from the account’s credit limit. So just like any other loan, interest may be charged on the balance. How and when this interest is charged can have a huge impact on what you pay for the use of your credit card.
To make sure your credit card works for you, here you will find answers to the most common questions about interest, including the different rates that may apply and when they are charged. We also look at how to compare credit card interest rates and take advantage of interest-free days so you can avoid interest charges.
What are credit card interest rates and how do they work?
Interest rates are a type of fee that are charged when you borrow money. With credit cards, interest rates are calculated as a percentage of your balance and shown as an annual or per annum figure. For example, a card could have an interest rate of 9.99% p.a. (per annum) or 21.99% p.a.
Most credit cards also have different interest rates for different types of transactions, with the most common being a purchase rate and a cash advance rate. You can learn more about different types of interest rates below.
How is credit card interest calculated?
The interest rate on credit cards is normally shown as an annual figure. However, most credit card companies calculate interest on a daily basis and then add the charges to your account at the end of each statement period. To determine your credit card interest amount, your daily outstanding balance is multiplied by the daily interest rate on your credit card. These daily calculations are then added together at the end of the statement period to obtain the total interest due. The daily interest rate is calculated by dividing the annual percentage rate (APR) by 365 days.
Compound interest costs
The way credit card interest is charged is known as “compound interest” because it is calculated daily. This means you can end up paying interest on your interest charges. The good news is you can cut down on interest costs any time you make a repayment, because that also affects the daily interest calculation.
Types of credit card interest rates
Here are the most common types of interest rates you find on credit cards:
- Purchase interest rate. This is the interest you are charged when you use your credit card for making payments in retail outlets or online.
- Cash advance interest rate. This is the interest rate charged when you use your credit card for withdrawing cash from ATMs or cash equivalent transactions, like buying gift cards or gambling.
- Balance transfer interest rate. This is the interest rate you are charged when transferring an existing credit card debt to a new card.
- Promotional interest rate. Many credit card companies offer new customers a promotional interest rates for purchases and/or balance transfers. This promotional interest rate is only available for a limited time; with the standard interest rate applying after that. For example, a card may offer you 0% interest on balance transfers for the first 12 months. If you don’t pay off the balance transfer during the first 12 months, the standard rate for balance transfers will apply to the debt.
Even the smallest difference in credit card interest rates can have a huge impact on your account costs. So when you are looking for a new card, make sure you compare both the standard and promotional interest rates to help you find one that suits your needs.
Comparing credit card interest rates
To show you how important it is to compare interest rates, let’s say you have a balance of $1,000 on a credit card with an interest rate of 20.99% p.a. If you only make monthly payments of $50 on this debt, it will take you around 2 years to pay off your balance and cost you about $212 in interest.
On a credit card with an interest rate of 15.99% p.a., it will still take around 2 years to pay off your balance but will cost you $153 in interest. That is a saving of $53, compared to the card with a higher rate, which is basically another monthly repayment. The bigger the difference in rates, the greater the potential savings will be.
What else do I need to know?
As well as interest rates, make sure you consider the following when you are looking for a new credit card:
- Interest-free days. Many credit cards offer up to a certain number of interest-free days on purchases when you pay your account balance in full by the due date on your statement. For example, up to 55 days interest-free. This gives you a way to avoid interest charges for spending on your credit card.
- 0% interest rate offers. If you get a credit card with a promotional 0% interest rate, it may only apply for certain types of transactions. For example, you could get 0% interest on balance transfers for 12 months but still have to pay the standard variable interest rate for purchases. There is also a range of credit cards that offer introductory 0% interest rates on both purchases and balance transfers, although standard rates apply at the end of the promotional period.
- Annual fee. Most credit cards charge an annual fee, which can also add to your account balance. Remember to factor this cost in when you are comparing credit cards and also when budgeting for interest cost and repayment.
- Other features. Many credit cards offer complimentary extras such as insurance or rewards, which may help offset the cost of the annual fee and interest charges. Just remember to weigh the value of the benefits against potential costs so you can decide if a card is worth it based on your spending habits and goals.
Compare credit cards for 2020
If you are looking for a new credit card, you can use our comparison table below to compare your options based on interest rates.
When applying for a credit card, it is important to read the fine print so you understand all the terms and conditions of the agreement. If you don’t take the time to understand the fees and charges associated with using your card, you could end up with a nasty financial surprise in the future. Do your research and read all paperwork thoroughly.
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