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When paying off debt, it is important to understand how much you are paying for the different parts of debt and why. This is why it is critical to understand how credit card companies compute your interest and fees. Once you understand this, you can make better decisions on how you purchase goods and services on a daily or monthly basis and prioritize which of your credit cards to pay off first if you have several cards with outstanding balances.
Credit card interest is how credit card companies mitigate the risk of lending cash to cardholders. Some people will get approved for a $500 credit card, charge up $500, and never pay a penny on it.
If you don't take good care of your credit, then your credit won't take good care of you.” ― Tyler Gregory
For this reason, the card issuer will review your credit before issuing you a credit card to determine how much of a risk you are and assign you an interest rate accordingly. If you are never late on paying off your balance in full, your interest rate is irrelevant. If you miss a payment or can only make a partial payment, you can calculate your monthly effective finance charge in three simple steps. Of course, some credit card companies charge more than just interest, so be sure to look out for other common fees.
What Is Credit Card Interest?
Credit card interest is a fee credit card companies charge you to mitigate the risk of default. If you only pay off half of your balance before you stop paying your monthly bill, the interest helps to offset the rest of the balance you still owe. If you pay your credit card balance in full and on time every month, you will never pay a penny of interest. However, for many of us, this is not an option.
When you apply for a credit card, the card issuer such as a bank or credit union will run a hard credit check on you to determine your creditworthiness. The better your credit history, the lower your interest rate. Common credit card interest rates are between 7 and 36%.
How Do Credit Card Companies Calculate Interest?
When you read the paperwork that comes with a credit card, it may seem hard to understand how credit card companies calculate interest. However, it is actually a simple three-step process.
Calculate The Daily Rate
Say you have an 8% APR (annual percentage rate) on your credit card. This is the same as the number 0.08. Divide this number by 365 to convert your annual interest rate to a daily interest rate. Some banks divide by 360 days per year, but the difference is insignificant. If this information is not easily found in your paperwork, it isn’t a big issue. The difference is less than 1.4% of your APR. This number is sometimes called the daily periodic rate or the periodic interest rate. The daily interest rate on a credit card with an 8% APR is 0.02% per day, or 0.0002.
Determine Your Average Daily Balance
Your credit card statement will tell you the days included in your credit card company’s billing period. To find the average daily balance for the billing period, start with the unpaid balance. For example, say your current unpaid balance is $. Now, add all charges approved during the billing period. Pending transactions do not count.
Let’s say all of these charges add up to $$. When added to your beginning balance, you’re now at $$$. You also made a payment of $during this billing period. Your ending balance will be $$, the net of your beginning balance, all charged transactions, and all payments.
Now, divide this number by the number of days in your billing period. Most billing periods range between 28 and 31 days, and this will be clearly stated on each of your credit card statements. For the sake of argument, let’s call it 28 days. Divide $$by 28 days to get an average daily balance of $.
Calculate The Interest
Multiply your daily rate from step one by the average daily balance in step two. In this example, you would multiply 0.0002 by $ to get $ in interest per day. Multiple that by our 28 day period and you get $ per month in interest.
What Other Fees Might Credit Card Companies Charge?
Some cardholders pay their entire balance on time every time, but many more credit card users carry a balance from month to month. While those who pay off their balances won’t have to pay interest, that may not prevent card companies from charging them some other fees. Here are examples of fees credit card companies charge to generate revenue from customers who do not pay interest and to offset the costs of rewards and processing fees.
Many rewards cards have annual fees attached to them. For cards with excellent rewards, the fee can be as high as $500. For those with lesser rewards, the annual fee may be as low as $19. Do a careful cost analysis to determine if the credit cards with the higher annual fees provide rewards than are worth the cost. If you are shopping for a credit card, look for one which waives your first year’s annual fee.
Balance Transfer Fee
If you transfer your credit card balance, in part or in full, to another credit card, you will often be charged a balance transfer fee. The average fees for this service is usually $ or 3%, whichever is greater. If you are transferring $$, you will be charged $ rather than $. If you transfer $$$, your balance transfer fee may be $$ rather than $. Many companies offer zero percent balance transfers for 12 to 18 months to get customers to switch to their card.
Cash Advance Fee
If you take a cash advance or equivalent transaction, credit card companies usually charge a cash advance fee. This is usually 5% of the advance amount or $, whichever is greater. This fee applies to transactions such as credit card convenience checks, overdraft protection, and using your credit card at an ATM for cash. This is on top of any out-of-network ATM fees if applicable for your transaction.
Expedited Payment Fee
To make a last-minute credit card payment by phone to avoid a late fee, you may be assessed a $ to $$ expedited payment fee. However, with late fees between $ to $$, it’s better to pay this fee than to miss a payment.
Some credit card companies waive the first late fee for customers. However, after this you will almost always be charged a late fee unless you call and ask for a reprieve. You have the greatest chance of success if you have had no late fees in six months. Late fees are usually around $unless you have been late in the past six months, in which case the fee may be higher.
The maximum late fee a bank can charge annually is based on inflation. Late fees will be assessed for six months. If you have not made a payment within that time, your credit card account will be sent to collections. Contact your credit card issuer for a payment plan to avoid this since it can negatively affect your credit score for up to seven years.
Foreign Transaction Fee
If you make a purchase with foreign currency, credit card companies charge you a foreign transaction fee. This is independent of your physical location. If you are in the United States but use your credit card to pay 29,000 yen for a video game console shipped from Japan, you may be charged around three percent of the transaction amount. Look for a credit card that does not charge a foreign transaction fee if you are in the military or have some other reason to travel abroad frequently.
Returned Check Fee
Your bank can charge you up to $ every time you send in a credit card payment by check and that check bounces. This is separate from any fee your bank would charge you for writing a bad check. If this is a recurring issue for you, carefully consider the cost of overdraft protection fees for your checking account. They are likely far less than the double fees you get for writing a bad check from both your bank and your credit card company.
The Credit CARD Act of 2009 makes over-limit fees rare, but they still occur. the law requires you to opt in to having over-limit transactions processed before you can be charged an over-limit fee. This fee can be no greater than $$ and charged for no more than two billing cycles while your balance remains over the limit.
Opt out of over-limit fees or keep your credit card balance below the credit limit to avoid these costs. This means if you have an emergency that would push your balance over the limit, you’re out of luck. To mitigate this risk, keep emergency cash in your car or purse. Opting out can save you from paying a $$ fee for a $ candy bar at the convenience store because you did not check your available credit first.
Even with the best of planning, we all fall on hard times. Sometimes, we cannot pay off our entire credit card balance on time. Maybe you have $$$ in credit card charges over several cards but only have $$ for debt repayment.
Calculate the monthly interest you will be charged on each card to determine where best to apply your money. To do this, calculate your daily interest rate for each card by dividing your APR by 365. Then, calculate your daily average balance by dividing your monthly ending balance by the number of days in your billing period, located at the top of your credit card statement.
Finally, multiply your daily interest rate by your average daily balance for the period.
Your interest rate is irrelevant if you do not spend more than you can pay back within a billing cycle. More important factors to consider when looking for a new credit card are other charges such as balance transfer fees, cash advance fees, and annual fees. Read all paperwork carefully before applying and again before signing for a new credit card.