Credit card interest rates explained

Credit cards love to dish out teasing promises: “0% interest on purchases and balance transfers for 12 months”; “9.9% fixed APR”; “3.99% life-of-balance transfers!” But these promotional rates are sometimes just a guise; they have little to do with how much a credit card will actually charge you. If you carry a balance on your credit card – even sometimes – the interest rate you pay can make the difference between credit cards being a convenient financial tool and or a personal finance nightmare.

Sorting Out Credit Card Interest Rates

Every credit card has to clearly list its interest rates, fees, and other card member terms – either on the back of a printed card solicitation or on a webpage linked from the bottom of a credit card application page. (Hint: Check the fine print at the bottom). Knowing how to read these credit card terms is critical to finding a credit card that will not rip you off.

When reading credit card terms, you will encounter several different types of interest rates. Here is what they all mean:

The annual percentage rate (APR) is the annual interest rate you are charged on purchases on your credit card. For all intensive purposes, the APR is your interest rate.

The prime rate is the interest rate used by banks to set the bar for all interest rates for loans. The prime rate fluctuates over time – historically between 6% and 10%. The rate is based upon monetary policies set by the Federal Reserve, and listed everyday in The Wall Street Journal. Many credit card interest rates vary according to the prime interest rate. For example, a credit card interest rate may be listed as “Prime + 5%”. If the prime rate were 6.25%, that credit cards’ interest rate would be 11.25%.

A fixed interest rate or fixed APR means an interest rate that does not fluctuate unless the card issues decides to alter the rate and notifies the cardholder, in writing, about the change. Some credit cards will advertise their rates as “fixed for life”. Sounds tempting, but credit cards can – and will – legally change your rates anytime they wish. It makes sense to find a low fixed interest rate card when the prime interest rate is on its way up.

A variable APR is an interest rate that changes on a regular basis based upon a benchmark interest rate such as the prime rate. Variable interest rate cards can often be better deals when interest rates are low, but can quickly loose their appeal when interest rates are on the rise.

Borrowers with preexisting credit card balances will likely want to find a credit card that offers a teaser APR, or promotional rate. Many cards offer temporary interest rates that apply to either balance transfers or purchase (sometimes both). These rates can be as low as 0%. While these introductory rates can save you a lot of money on interest charges and help you pay off a credit card debt faster, you need to be very careful about special terms attached to such rates.

For example, if you transfer a balance to a credit card with a 0% interest rate on only balance transfers, and then make a purchase with the card. The card’s regular APR – let’s say it’s 14% — will be applied to that purchase. Then, as you make payments to your credit card, those payments will be applied to the balance transfer, at 0% interest – before they are applied to the purchase at 14% interest – meaning you will be paying finance charges on that purchase until your transferred balance is completely paid off.

Additionally, credit card companies will take away a teaser rate immediately if you break any of the terms in the card member agreement. For example, if you are late with a payment, if you go over the credit limit, or if you bounce a check to the credit card company. Some credit cards will even raise your interest rates if your overall credit score declines for any reason. This could include carrying too high a balance on another credit card, making regular late payments, or defaulting on a loan.

How Credit Cards Apply Interest Rates

Believe it or not, the percentage interest you are charged annually isn’t the only factor that determines how much you will pay to a credit card to carry a particular balance. Credit cards calculate your balance (to which the interest is applied) in different ways. Most credit cards use the average daily balance method, which is computed by adding the balance you are carrying every day in a particular month and dividing that total by the number of days in the month.

With the average daily balance method, for example, if you are carrying a $1,000 balance for the first 15 days of a 30 day month, pay it off in full, and do not carry a balance for the next 15 days, you will be charged interest on a balance of $500 that month.

Some credit cards may use what they call a “two-cycle average daily balance method” which means that they average two months of balances instead of one, often resulting in a higher finance charge because you will continue paying interest on purchases for up to two months after you have paid them off.

The good news is, however, most credit cards provide a grace period to pay off new purchases. Grace periods range from 20 to 28 days. Two important things to realize about grace periods, however: your credit card bill’s due date may be later than the end of the grace period. And, if you do not pay off your credit card bill in full each month, interest will be applied on new purchases from the day they post.