When applying for a new credit card, most people will pay close attention to several different things. It could be the signup bonus or the rewards they can earn. But the one thing that should always be on your radar is the effective annual percentage rate, or APR, on the card.
On the surface, you might think you have a good understanding about what an APR is and how it’s calculated. However, it can be confusing and you can easily be left uninformed. To help you become a more empowered consumer, we'll walk you through the basics: When interest is charged on accounts, how the interest is actually calculated, and what can affect the APR you receive.
When Will Interest Be Charged?
A little-known perk of most credit cards is that they come with a grace period. This is the period of time from when your credit card statement closes to its actual due date. The number of days depends on the card issuer, but it’s typically at least 21 days. With most cards, if you pay your entire statement balance before the grace period ends, then no interest will be charged. However, if you only pay a portion of your balance before the due date, then interest will begin to accrue on the purchases you made. (Remember, credit cards don't have to offer a grace period so be sure to read the fine print of a card you're considering to see if it offers one.)
How Do You Calculate Interest?
If you are carrying a balance on your credit card, you'll likely see the interest payment on your statement. But do you know how that figure was derived?
To start, it’s important to understand some terminology. We frequently see APR mentioned in credit card terms. Even though this means annual percentage rate, interest is not calculated on an annual basis. It’s actually calculated on a daily basis, which is more commonly known as the periodic interest rate.
So let’s assume your card has an APR of 16%. To figure out what the periodic interest rate would be, you would divide 16 by 365 days (some card issuers use 360). That means your periodic interest rate would be 0.044% per day. You’re probably thinking that doesn’t seem like a lot, but over a month or a year it can really add up, depending on your balance.
Once you know your periodic interest rate, you need to find out what the average daily balance on your card was. Let’s assume that you have a $2,000 balance at the beginning of the month, and you don’t pay any of it for the first 15 days. Then it’s payday and you are able to pay off $500 on the 16th. Then you pay off another $500 on the 25th of the month. That means your daily average balance would be ($2,000 x 15 + $1,500 x 9 + $1,000 x 6) / 30 = $1,650.
Now that you know what your periodic interest rate would be and you know your daily average balance, you can put them together to figure out what your monthly interest charge would be $1,650 x 0.044% x 30 = $21.78.
What Can Affect Your Credit Card APR?
Most credit cards will state they use a variable APR. This means that the rate can move up and down based on different factors. Some of these factors are directly in your control, while others are controlled by outside influences. Just keep in mind that any rate changes need to be communicated with you 45 days ahead of time, per the CARD Act.
Something that is in your control is your creditworthiness. When you apply for a credit card, the issuer is going to want to make sure you are going to be able to pay back the money you borrow. They also may look at your FICO score, among others. The higher your scores, the lower your APR will be. (Not sure where your finances stand? You can view two of your credit scores for free on Credit.com.)
However, another factor is something called the prime rate. This is defined as the lowest rate of interest at which people may borrow commercially. When the Federal Reserve moves rates (as it did very recently), it can either positively or negatively affect a credit card's APR. If the Fed raises rates, your APR might go up. If the Fed lowers rates, you APR could go down.
By understanding how your credit card company calculates the interest on your card, you will become a more empowered consumer and have a better appreciation for paying off your statement balance in full each month.
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