Save Money by Understanding How Credit Card Interest Works

Credit card interest rates can be confusing, but we break down what you need to know and how to avoid paying interest on your purchases.

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Credit cards can be helpful in many situations. You can use cards to earn rewards, receive purchase protection, and finance large or unexpected purchases. However, credit cards often have high interest rates, and understanding when and how credit cards charge interest can be important for managing your finances.

Your Card's Annual Percentage Rates

Credit cards display their interest rates as annual percentage rates, or APRs. Your card's APRs can depend on the type of card, current market rates and your FICO® Score. And the rates will determine the amount of interest that could accrue on your card's balances.

Here are four important things to remember:

• Credit card APR doesn't include fees**: A credit card's APR is its interest rate and the APR doesn't include any potential fees, such as annual, balance transfer, cash advance or late payment fees. In contrast, loans can have interest rates that are different from their APRs because the APRs include mandatory fees, such as origination fees.
• Your account could have several APRs: Credit cards may have different APRs for different types of transactions — one each for purchases, balance transfers and cash advances. Some cards also offer installment plans with different rates or fees that you can use to pay off eligible purchases.
• Promotions can temporarily lower your APR: Some credit cards offer a temporarily lower APR, sometimes down to 0%, for purchases, balance transfers or both types of transactions. You can commonly find these offers when you apply for a new card, and some card issuers offer existing cardholders promotional APRs as well.
• Missing payments can lead to a penalty APR: Many credit cards have a penalty APR — a higher interest rate that can be applied to your entire balance and future transactions if you miss your payment by 60 days.

Knowing how much interest might accrue on your card is important if you're considering paying off a purchase over time, but there are also ways to use credit cards without paying any interest.

When You Pay (And Don't Pay) Interest

One of the most important things to remember about credit card interest is that it only accrues on your purchases when you revolve a balance.

• Purchases often have a grace period: Most credit cards offer a grace period on purchases, meaning your purchases won't accrue interest between the end of your billing cycle and when your payment is due. However, you only receive the grace period if you pay your bill in full each month. In other words, your purchases won't accrue any interest if you always pay your entire balance.
• Balance transfers and cash advances don't have grace periods: Balance transfers and cash advances generally start to accrue interest immediately.

People often use promotional balance transfer offers to move debt from credit cards with high APRs to one that temporarily offers a lower APR. This might be a good strategy that helps you save money and get out of credit card debt sooner. But read the fine print.

Unless the promotional APR applies to balance transfers and purchases, your new purchases might accrue interest while you're paying down the balance transfer. This happens because you're revolving the balance transfer balance, which can void your card's grace period.

Also, watch out for deferred interest offers. With many promotional APR offers, only the remaining balance accrues interest after the promotional period ends. However, with deferred interest offers, you'll have to pay all the interest that accrues during the promotional period if you don't pay off the entire balance by the end of the period.

How Credit Card Interests Accrues

When you revolve part of your balance from one month to the next, you'll lose your grace period, and your purchases will start to accrue interest daily. Cards might use slightly different methods to calculate your interest charges, but here's an approximation of how it works:

• The card issuer calculates the daily APR: Divide the card's APR by 365 to find your card's daily periodic rate. For example, a card with a 25% APR will have a daily periodic rate of 0.068.
• Multiply the daily rate by the balance at the end of the day: The daily rate gets multiplied by the card's balance at the end of the day to determine how much interest accrues that day.
• Add the interest to the balance and repeat: The interest gets added to the balance along with new transactions, such as purchases or payments, for the day. Then the process repeats, leading to daily compounding interest.
• Add up all the accrued interest at the end of the billing cycle: At the end of each billing cycle, all the accrued interest is added together and listed on your bill. Balances with different APRs may be listed separately.

The timing of credit card bills and the daily interest accrual can also lead to residual or trailing interest — when interest accrues between the arrival of your statement and your bill's due date.

It's especially important to watch out for residual interest if you pay off a card or transfer its entire balance and don't plan on using it again. Keep an eye on the account for a couple of months to make sure you don't accidentally wind up with a late payment.

Credit Card Interest and Your FICO® Scores

The interest rate on your credit cards doesn't directly affect your FICO® Scores. However, high-interest debt can be more difficult to afford, and falling behind on payments can hurt your FICO Scores. Carrying a large balance relative to your card's credit limit — a high credit utilization ratio — can also be a negative factor.

Butdon't believe the myth that you have to carry a credit card balance. As you've learned, paying off your balance in full each month can help you avoid accruing interest — and it can also help avoid negatively impacting your FICO Scores with late or missed payments.

Get your FICO® Score from FICO, for free. No credit card required.

Louis DeNicola

Louis DeNicola is a finance writer based in Oakland, California. He specializes in consumer credit, personal finance, and small business finance, and loves helping people find ways to save money. In addition to FICO, Louis works with a variety of financial services firms, credit bureaus, and educational websites, including LendingTree, Credit Karma, and Experian.