If credit card companies were forced to indicate the cost of borrowing at the top of a credit card statement in large red print that filled half a page, we’d probably never carry a balance again. If you aren’t careful, over the course of a lifetime, credit card interest can cost as much as a new car – and maybe that cross-country trip you always wanted to take as well. A report from Credit.com estimates that the average lifetime cost of debt, including mortgages, auto loans, and credit cards, is nearly $300,000.[1] Of those three types of credit, credit cards are usually the costliest as a percentage of the balance and often the most difficult to pay off.
A large part of the reason that credit card balances are so difficult to pay down is because credit cards use compound interest to calculate your interest expense. Most home and auto loans use simple interest and paying down these types of loans is a direct and predictable process. Credit cards add interest to the balance and then continue adding interest to the balance until the card is paid off, which makes paying off a large balance a long process for many households. In effect, you’re paying interest on the interest as well as your purchase balance. Some consumers spend a lifetime paying credit card bills and never manage to pay the balance off in full.
Most credit cards use a variable rate for interest charges, which means that credit card interest rates go up when the prime lending rate goes up. Many credit card lenders price interest rates using a prime-plus method. For example, your rate may be at prime plus 13%. If the prime rate is at 5%, your interest rate is 18%. The difference between prime and your rate is called a spread. If your credit score and payment history are excellent, generally, you can expect a lower spread, and a lower interest rate. The opposite is true if you have a lower credit score or have been late on payments; the spread is likely to be higher, making your interest rates higher as well.
When you accept a variable interest rate credit card, the credit card company doesn’t need to notify you in advance of interest rate changes. Rate increases just happen – and even when listed on a credit card statement are easily overlooked. Rates can creep up for months or even years before a consumer investigates and reads all the pages of a credit card statement in detail. In many households, when the statement arrives, some amount above the minimum payment is paid according to what the budget allows that month. Often, the details of the cost of interest or any changes to the rate are missed altogether.
How is credit card interest calculated?
First, the good news: If you pay off the balance in full when you get the statement, you won’t pay interest on that balance. In this regard, credit cards are great because you can borrow money without any cost. Consumers who purchase with a credit card and then pay off the balance immediately are called transactors. However, only about 29% of credit card holders are transactors. A much higher percentage are revolvers, which means they carry a balance from one month to the next. About 44% of credit card holders carry a revolving balance. The remaining percentage, about 27% are dormant, which means they rarely use credit cards in any way.
Credit card companies make their money from revolvers. If you carry a balance from one month to the next, interest is applied to the balance. Credit card companies are counting on a large percentage of credit card holders to carry a balance, and so far, they’ve been right.
You may be familiar with the APR for your credit card, which is the annual percentage rate. However, interest is calculated daily for the balance you carry on your card. The daily interest is called the daily periodic rate (DPR). This is easy to calculate because you would divide the APR by the number of days in a year. An 18% APR has a daily periodic rate of 0.0493. Some lenders use 360 days instead of 365 to calculate the daily period rate. This works out to a slightly higher daily periodic rate of 0.05.
Credit card companies also use your daily average balance to calculate interest. To use a simple 1-month example, if you had 15 days with a $500 balance and you had 15 days with a $1,000 balance, your average daily balance would be $750. The math is much more complex for consumers who carry a balance and use credit cards regularly.
For our simple example, the math looks like this:
$500 x 15 days = $7,500
$1,000 x 15 days = $15,000
Total = $22,500
$22,500 divided by 30 gives you an average daily balance of $750.
If your daily periodic rate is 0.05, you would multiply that rate times 30 days in a month to get your monthly rate.
0.05 x 30 = 1.5
The 1.5 is a percentage so it can be divided by 100 to get a number we can work with easily. Apply your monthly rate to the average daily balance.
$750 x .015 = 11.25 monthly interest.
For most consumers who carry balances, the average daily balance is much higher. The average credit card debt for households that carry balances is over $9,300.[2] At 18% APR, a balance of $9,300 costs $139.50 each month using the same formula.
$9,300 x .015 = $139.50
If that balance never goes down, the annual cost of interest on the carried balance is $1,674 per year.
How are minimum payments calculated?
The method of calculating your minimum payment can vary from one card to the next, but most commonly you’ll pay about 2% or 3% of your total balance.
To use the average balance for card holders who carry a balance, $9,300 with a 2% minimum payment equals $186. Earlier we calculated the monthly cost of that balance to be about $140. Only $46 will be applied to the balance, which means the balance will be with you for a long, long time.
A $9,300 balance at 18% APR with only a 2% minimum payment paid each month looks like this:
Months to pay off: 596 (that’s 50 years)
Interest expense: $26,296.78
The interest expense is nearly triple the amount of your purchases and you’ll be paying off the balance for five decades.
Check your credit card statement to see how the minimum balance is calculated. Credit card issuers use various methods, with 2% of the balance being among the most common methods. Regardless of what method your credit card company uses, you’ll want to pay significantly more than the minimum. Paying only the minimum can leave you in debt for the rest of your life if the balance is high.
Different types of APR
Credit cards come with more than one type of APR. Depending on certain triggers, you may be paying the rate you expected when you signed up for the card – or you may be paying a higher rate. It’s even possible for your account to have more than one interest rate at a time. If this is the case, the charges will be listed on your credit card statement, detailing the balance amounts subject to each rate.
- Promotional APR: It’s common for credit card companies to offer a promotional rate to entice new customers or encourage balance transfers. A promo rate typically lasts for up to 18 months. In some cases, the promotional rate only applies to balance transfers while new purchases are at a higher rate. Read the fine print on the offer carefully. After the promotional period expires, the regular APR applies. Promotional APR offers are more attractive if you know you can pay off the balance before the promo period expires.
- Regular APR: Your regular APR is the amount you pay if no other rates apply. If you didn’t choose a card with a promotional APR and haven’t made any cash advances or incurred any penalties, your account should have only one APR.
- Cash Advance APR: We’ll discuss cash advances in more detail, but your credit card usually has a higher APR for cash advances. The higher rate will apply to the amount you’ve taken as an advance until that balance is paid off. Other purchases will use your regular APR – unless you qualify for a promo APR or have incurred a penalty APR.
- Penalty APR: If your payment is late by 60 days or more, your account can be subject to a penalty APR that can reach as high as 29.99%. Credit card companies can apply the penalty APR to both existing balances and future purchases. However, if you keep your account current for 6 months following a penalty, credit card companies are required by law to apply your regular APR on existing balances. There is no requirement to remove the penalty APR on new purchases.
Balance transfers
Credit card companies use balance transfer offers to entice consumers with the promise of saving money. In the short term, a balance transfer can save money in some cases, but it’s important to study the details of the offer. If you have good credit, the balance transfer offer can be as low as 0%. In some cases, you may be able to transfer other types of loans to a credit card as well, like auto loans, mortgages, home equity loans, or payday loans. Apart from payday loans, it’s difficult to find a benefit in transferring these other types of balances because the way interest is calculated on a credit card is less advantageous to consumers. The promotional APR for balance transfers is for a limited time.
Balance transfers often have a one-time fee which is applied to the balance being transferred. This fee can be as high as 5%, but averages under 3%. The fee can make a low APR balance transfer offer less attractive because it increases your debt by the amount of the fee. A $10,000 balance that is transferred with a 5% fee becomes a $10,500 balance. It’s possible that you may be paying off the additional $500 and its interest for years, so be careful if choosing a balance transfer.
If used as a tool when paying off high-interest credit card debt, balance transfers can play a viable role. However, utilizing balance transfers if you are using credit for impulse purchases isn’t likely to yield long term benefits. Balances will continue to climb, creating more expense and the risk of late payments which can lead to penalty APRs.
Cash advances
Many credit cards offer the option of taking cash advances. Be aware of the costs associated with cash advances before swiping your card at an ATM. Cash advances are subject to a higher APR, which can be above 25%. You can also expect to pay a one-time fee for the advance, which usually ranges between 3% to 5%. A $1,000 cash advance with a 5% fee will create a balance of $1,050, to which your higher cash advance APR will apply. Cash advances can be a costly way to get cash. Unlike credit card purchases, the interest charged for advances begins to accrue from the day you take the advance.
When you make payments that are above the minimum, credit card companies must apply the “extra” payment to the highest APR balances, which will bring down the cash advance balance over time. However, if you are only paying the minimum or your extra payments are small, the higher APR balance for cash advances can cost you money for years to come.
Fees
Interest isn’t the only way credit card companies make money. Credit cards also have several types of fees, but many can be avoided. Here are some additional fees that may apply in certain situations:
- Annual fee: An annual fee can be as high as $500.
- Cash advance fee: Cash advance fees can be as high as 5%.
- Balance transfer fee: Balance transfer fees can be as high as 5%.
- Expedited payment fee. If you need your payment applied right away (because it’s due now), a fee of up to $15 may apply.
- Foreign transaction fee: Expect to pay a fee of up to 3% for purchases when traveling in other countries. Not all cards charge this fee, however.
- Over-the-limit fee: If your balance is over the limit, lenders can charge a fee of up to $35 per billing cycle for a maximum of two consecutive months if the balance remains above the limit.
- Late fee: Fees for late payments range from $27 up to $38.
- Returned check fee: The fee for returned checks is up to $35. If the payment is returned a second time, another fee applies.
Fees are applied to your balance and accrue interest just like purchases. If you carry a balance, you could be paying for fees for months, years, or even decades.