- Understanding how credit card interest works empowers you to make choices about how you use your credit card to your advantage.
- A purchase interest charge is applied only to purchases of goods and services. It tends to be the lowest of the interest rates you can incur.
- Carrying a hefty debt from month to month can cause your interest charges to snowball. There are some techniques that you can use to help manage your credit card debt.
In a recent Credit Card Market Monitor publication, the American Bankers Association highlighted an increase of new American credit card accounts by nearly 2% over the last year. Although more Americans are starting accounts, consumers need to be careful before jumping in and blindly opening a new card. They must take time to research essential terms and concepts, like purchase interest charge, before opening their first first credit card.
Failure to understand how credit cards work could have long-lasting financial implications. In this article, we’ll take a closer look at purchase interest charge, which is what credit card companies will charge if you don’t pay your balance in full each month.
How Do Credit Cards Work?
If you don’t have a credit card, you must either make purchases with a debit card or cash. You must always have these on you to make purchases, and you’re limited to the amount of cash you have on hand or the funds in your bank account. Cash and debit cards are typically not accepted as forms of payment for online purchases, when booking a hotel, or when reserving a rental car.
Credit cards provide you with significantly more convenience. Credit cards come with a line of credit, or the maximum amount that you can borrow. Credit cards allow you to make purchases now and pay for them later. They also provide much more flexibility in terms of the things you can buy.
Credit card issuers must take steps to ensure that you repay your debt. One way in which they do so is by applying various interest rates to the card. These interest rates may be buried deep in the fine print, but they’re quite important, as they can cause you to accumulate debt quickly.
When learning how to calculate interest on a credit card, you must consider what type of interest you’re calculating. Examples of credit card interest charges include:
- A purchase interest charge is what you owe on any balance after a billing cycle
- Introductory interest rate is the promotional rate that lenders will offer when you apply for the card
- Balance transfer interest rate is what you’ll be charged when bringing debt from other cards onto the new card
Each of the interest rates charged by a credit card company is expressed as an annual percentage rate, or APR. Knowing how to calculate APR is beneficial, as this is how your interest charges will be applied to your purchases, cash advances, or other transaction types available on your credit card.
Having a sound understanding of interest charges allows you to use your card to your advantage, keeping more money in your pockets rather than the hands of credit card lenders. Of the various types of credit card interest, purchase interest charges tend to be the most common. Let’s take a closer look at what purchase interest charges are and how they work.
What Is a Purchase Interest Charge?
A purchase interest charge, or “finance charge,” is the interest that you pay on your average daily balance for any purchases that you made without paying in full by the time the payment is due. When you open a new credit card, you’ll find that you have a billing cycle, which is typically about a month’s time. At the end of each billing cycle, your credit card lender will tell you how much you owe.
So, let’s say that you have an average spend of $1,000 on your credit card in one month and that your card carries a charge interest rate of 18%. You pay only half of the balance by the due date rather than the full amount. The credit card company will first collect the interest charges of $15 ($1,000 x 0.18 divided by 12 months), then apply the remaining $485 payment to the balance that you owe. You will start the next billing cycle with a balance of $515. Note that even though you made a partial payment, the credit card company is entitled to charging you full interest on the average balance since they loaned you that amount for the full period prior to the payment date.
Purchase interest charges apply only to goods and services. It is often the lowest of the interest types, compared to cash advance or penalty interest charges for example, that you can incur.
How to Avoid Paying Purchase Interest Charges
The best way to avoid paying interest on purchase interest charges is by paying your entire balance on your credit card statement before the payment due date. That period between when your credit card statement is issued and the payment due date is called the payment “grace period.” So long as the credit card company receives your payment before the grace period ends, you avoid paying interest.
There are other types of grace periods that you can take advantage of. Companies may grant cardholders introductory grace periods, which is a defined number of days in which they won’t charge interest. Introductory grace periods tend to last anywhere from one month to a year. If you pay off your full balance within this grace period, you’ll avoid having to pay interest completely. Watch out, however, that you don’t forget to schedule your payment of the full balance when it’s due, because the interest on these types of promotions get charged on the day of your purchase and accrues from then.
How Does Credit Card Interest Work on Purchases?
Credit card interest is unique because it compounds, meaning you could get charged interest on the interest you haven’t paid. For instance, let’s say you have a purchase APR of 20%. You take your annual interest rate and convert it into the daily periodic rate by dividing by 365, which yields 0.0548%.
Now, say your unpaid credit card balance is $1,000. Based on the daily periodic rate, you’re charged about 55 cents on the first day day. This brings your balance to $1,000.55. Interest is then charged on this balance the next day. Interest from the unpaid debt is added to your debt and therefore builds on itself.
Now, what happens if you make a payment somewhere in the middle of the month? Instead of using the previous balance, lenders will use the average daily balance to determine interest rate charges. Average daily balances are a combination of the balance owed at the end of each day of the billing cycle, instead of how much you owe at the end of the month. So if you find that it’s difficult for you to pay off your balance for this billing cycle, you can get ahead by scheduling a payment mid-month or more frequently to bring your average daily balance down.
Your lenders will provide you with a minimum payment due each month. The minimum payment covers the amount of interest charged and a percentage of the balance. However, if spending goes unchecked, the minimum payment can skyrocket to unmanageable amounts because of interest. You must pay the minimum balance on time to avoid a severe impact on your credit report.
Lastly, there are other types of interest charges that you’ll need to be mindful of. For instance, lenders charge cash advance interest rates if you withdraw cash using your card. They also may charge a higher penalty rate if you miss payments. Lastly, lenders may use promotional or intro APRs, only to increase the rates if you don’t pay off the balance.
How to Manage Credit Card Debt
If you do find yourself racking up credit card debt, act quickly to avoid getting trapped by compound interest and ever-increasing balances. By using your card responsibly, you can boost your credit score and open yourself to new lending possibilities, from cash-back credit cards to mortgages. Responsible card use includes:
- Make timely payments. Lenders charge interest and penalty fees when you miss payments. Making on-time payments will help stop your spiral of debt. Even if you think you’d remember to make these payments when due, consider automating payments so that you don’t miss any each month.
- Don’t utilize too much credit. One of your credit score factors is your credit utilization or the total amount of credit that you use at any one time. Try to keep this number below 30%, e.g., if you have a $1,000 credit line, try not to use more than $300 at a time.
- Spread out purchases across multiple cards. If you own multiple credit cards, you can spread out smaller purchases, like recurring subscriptions, across them. You can then automate payments to pay the balance in full, which will help boost your credit score.
How to Pay Off Credit Card Debt
If you’re not careful, your credit card debt and quickly spiral. Credit card debt can have a long-lasting impact on your credit history. If you have debt and are looking for ways to pay it off, there are some things you can consider.
The first thing that you can do is limit or stop credit card spending past what you can afford to pay off each month. If you don’t pay your balance in full each month, purchase interest compounds on itself. So, even if you pay off debt from the previous month, you’ll quickly begin racking up purchase interest on this month’s purchases. Limiting your spending to a debit card for a couple of months while you pay off debt could help.
Second, make sure that you’re paying more than the minimum balance each month. As mentioned, the minimum balance is typically for the interest and a small portion of the balance — a mere drop in the bucket. Paying more than your minimum monthly payment can help you pay off debt.
Furthermore, credit card consolidation and balance transfers are an excellent choice to help consolidate debt. If you have debt spread across multiple cards, you can move the balances to a single card with a favorable interest rate.
The best way to pay off credit card debt? Aggressively. Aggressively paying off debt provides you with financial freedom so that you can begin rebuilding credit and saving money for future expenses.
Now that you have a better understanding of how purchase interest charges work, you can allow your credit card to start working for you, not against you. If you currently don’t carry a credit card balance, congratulations! That’s excellent news and a prime example of financial health.
If you do carry an outstanding balance on your credit card bill, remind yourself that each new purchase costs more than the actual price tag of the product or service itself because of the purchase interest charge and compounding interest. You can stay ahead of credit card companies by minding your spending and paying off the full amount of your statement balance each month. Eliminating your unpaid balance will not only increase your available credit, it will also help save you money and provide you with the satisfaction of winning. What more could you ask for?