It may be complicated, but understanding how credit card interest and annual percentage rates work is really in your best interest (pun intended).
It’s hard to win at the credit card game and make the best possible financial choices for you without a solid comprehension of what terms like interest rate, compound interest and APR mean. Luckily, you don’t need a degree in finance to understand the acronyms on your billing statement. Read on for a breakdown of the terms and what they mean.
Interest Is The Price You Pay
About half of all American credit card users at least occasionally carry a balance on their cards, according to a 2014 Gallup poll. That equates to millions of users who have paid interest charges on their credit cards.
In basic terms, the interest rate on a credit card is the cost of borrowing money. All credit card purchases are subject to a standard interest rate known as the annual percentage rate, or APR. The APR varies depending on the type of card and on factors such as a cardholder’s credit score. For instance, an airline credit card could have an APR anywhere from around 14 percent to as high as nearly 22 percent. Of course, there are also cards that offer low introductory rates, such as 0 percent APR on balance transfers or new purchases for a set period, such as 6 months to a year. These rates are great while they last, but keep in mind — they won’t last forever.
Your Daily Percentage Rate
The APR on your card is expressed in terms of a year, but most credit card companies calculate it over the number of days in your billing period. This is called your daily percentage rate. To calculate your daily percentage rate, take your current APR and divide it by 365. Every day, your card company multiplies your current balance by that daily rate to calculate the daily interest charge. You may also see your APR described as a periodic rate, and calculated by dividing your balance by the number of months in a year.
Now here’s the kicker: That interest charge is added to your current balance, so when the next day’s percentage rate is calculated it will be on that higher sum. This is called compound interest, and it’s a main source of revenue for credit card companies.
Conquer Compound Interest
Compound interest is not your friend when you’re carrying a credit card balance. The good news is that most companies give you a grace period — typically at least 21 days — between the date of purchase and the day your payment is due. You won’t pay any interest charges if you pay your entire statement balance in full and on time. If you don’t pay the balance in full, interest charges starting the day you made a purchase will be applied to your account and continue forward. In this circumstance, it’s like the grace period doesn’t exist.
Rates May Vary
Your credit card terms may include details on more than one type of APR: a purchase APR, a balance transfer APR, a cash advance APR and even a penalty rate APR for when you fail to make an on-time payment.
Also, it’s important to know if your credit card has a fixed or variable interest rate. A fixed rate is just that and it cannot change without advanced notice from your card company. A variable interest rate is tied to another interest rate, such as the prime rate, and can change as the index rate changes. Your card company does not have to give advanced notice when a variable rate changes.
If you receive notice that your rate is increasing, you can send an opt-out letter to your card company declining the rate increase. However, the company may decide to cancel your credit card, so you’ll have to weigh the cost of a higher interest rate with the chance of cancellation. Any rate increase notice sent to you will include information about how and where to send an opt-out letter.
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