How does credit card interest work?

The interest rate on a credit card is the cost you pay to borrow money from your card issuer. When you make a purchase using your card, the credit card company loans you the funds through a revolving line of credit, which you must repay in the future.

What does APR mean?

APR stands for annual percentage rate. It refers to a loan’s total borrowing costs, which include all fees in addition to the interest. As such, APR is a more accurate representation of your borrowing costs than the interest rate alone.

However, there’s no distinction between annual interest rates and APR when it comes to credit cards. The reason is that credit card issuers charge all fees separately to your account rather than combine them with interest charges. As a result, a credit card’s interest rate and APR will always be identical.

Knowing how credit card interest is calculated is essential. Most credit card companies use the daily balance transfer method to determine interest charges. Here’s how it works in practice:

Step 1: Divide your annual interest rate by 365 to figure out your daily percentage rate.

Step 2: Add each day’s ending balance during the billing period (which spans one month) and divide the sum by the total number of days in the billing period. The resulting figure will provide you with your average daily balance.

Step 3: Multiply your average daily balance by your daily percentage rate to get your daily interest charge.

Step 4: Multiply your daily interest charge by the number of days in the billing period. This figure is your total interest incurred for that period.

Credit card interest compounds daily, making its calculation more tedious than shown above. However, the difference is usually trivial unless you carry a large unpaid balance from month to month.

The grace period is the time between the end of your card’s billing cycle and the payment due date. Typically, it lasts 21 days; during this time, you’ll incur no interest on any purchases you make. As long as you pay your card’s entire statement balance in full within this period, you’ll never pay a cent in interest.

But what if you fail to pay off your outstanding balance before your grace period expires? How does credit card interest work in this scenario?

In this case, your credit card issuer will apply interest to your purchases going back to the transaction date. These interest charges will appear on your following statement. You’ll be responsible for paying them plus any remaining principal and fees.

In addition, you’ll lose your grace period, which means your account will accrue interest on new purchases you make during the upcoming billing cycle. Ouch!

The longer you carry your balance forward, the larger your credit card debt will grow, thanks to the compounding effects of interest.

How does credit card interest work with different types of transactions? That depends on how you utilize your card and your card issuer’s policies. Here are the most common credit card transactions and their associated costs:

Purchase. Everyday purchases are subject to the purchase APR, the default rate on your credit card. Typically, you can expect to pay between 8.99% and 20.99%. However, if you pay late too often, your card issuer can implement a penalty APR, which can climb as high as 30% or more.

While you don’t incur costs directly for regular credit card purchases, most credit card issuers levy currency conversion fees on foreign transactions. Most cards charge a 2.5% foreign currency conversion fee.

Cash advance. A cash advance is when you withdraw cash from your credit card account. Interest charges still apply, But unlike a standard purchase, there’s no grace period, which means your balance begins to accrue interest immediately. A cash advance APR is usually a few percentage points higher than a purchase APR. Cash advance fees also apply.

Balance transfer. A balance transfer involves moving your existing credit card’s balance onto a new card, usually one with a much lower interest rate. Balance transfer credit cards offer rates as low as 0%, though these enticing deals usually last only a short time (typically six to 12 months). Balance transfer fees generally range from 1% to 3% of the dollar amount you wish to move.

In Canada, standard credit card interest rates range from 19.99% to 20.99%, which is quite high. Therefore, you’ve got a bargain if you can obtain a card with a rate below this range.

But what is a good credit card interest rate? The answer will vary depending on what features, benefits, and rewards program you’re after. As a general rule, the lower the annual percentage rate, the fewer and more lacklustre perks you can expect. But, if your primary concern is to save money, hunting for the lowest-interest-rate credit card you can find is worthwhile.

Cards with interest rates below 15%, such as the CIBC Select Visa, are ideal. Some offer rates in the single-digits, as low as 8.99%. However, cards with such deals are elusive and reserved for individuals with excellent credit scores.

Borrowing money with a credit card won’t always lead to debt problems provided you use it judiciously. Here are some tips for minimizing credit card interest charges: