Understanding Credit Card Interest Rates

Stack of interest rate signs.

Offers for new credit card accounts are everywhere, from letters you get at home, emails that hit your inbox, and promotions you see on social media. Nearly all these offers promote an attractive annual percentage rate – APR – to convince you it’s a terrific deal you just can’t pass up.

Not so fast.

Before you sign up for a credit card, be sure you carefully review the fine print, especially if you have poor credit and are working to improve your credit score. The credit card agreement’s terms will become part of a legal agreement between you and the creditor. You’ll want to know those details, including:

  • What annual percentage rate is being offered and if it expires after a promotional period.
  • How the lender calculates the interest.
  • Any fees you’ll owe due to balance transfers, late and/or missed payments, or other violations of the credit card agreement.

The first step is understanding the APR and how it works.

What is APR?

The APR is the rate of interest that a credit card company charges you in exchange for lending you money. APR is important because it’s used to calculate how much your credit card debt is going to cost you above and beyond the account balance itself. The higher the APR, the more interest you will pay on balances you carry month to month.

In its most basic form, your APR determines how much interest will accrue after one year. For example, let’s suppose the APR on your credit card is 25 percent. If you have $1,000 in credit card debt, a 25 percent APR would end up costing you $250 in interest over one year.

In reality, calculating credit card interest is rarely that simple.

How does APR work?

Credit card companies usually calculate interest daily, making your daily periodic rate a more realistic number for determining how much you'll pay in interest. To calculate your daily periodic rate, divide the APR by 365 (the number of days in a calendar year). As an example, the daily period rate on a credit card with a 25 percent APR would be 25 ÷ 365 = 0.068 percent (or 0.00068 in decimal form). Some lenders use 360 instead of 365, and the math changes accordingly.

When credit card companies calculate interest daily, here’s how the arithmetic works on a credit card with an APR of 25 percent (daily periodic rate of 0.00068) with the following balances and a 30-day billing cycle:

  • Balance of $10 for 29 days
  • •alance increases to $800 on day 30
  • Calculate the average daily balance:
    • $10 x 29 days = $290; add $800 x 1 day; $290 + $800 = $1,090;
    • Divide $1,090 ÷ by 30 (the number of days in the billing cycle) = $36.33 average daily balance
  • Multiply the average daily balance of $36.33 by the daily periodic rate of 0.00068; $36.33 x 0.00068 = $0.025
  • Multiply $0.025 x the 30 days in the billing cycle; 0.025 x 30 = $0.75 in interest

How to shop for a good APR on a credit card when rebuilding credit

If you’re looking for a new card but you have poor credit, you’ll need to shop around, then compare and evaluate the credit card offers available to you. In general, the lower the interest rate you can get, the better.

Start by checking the current average credit card interest rate, which as of late November 2021, was just over 16 percent.

With a low credit score, you may not qualify for the lowest APR offers because lenders will consider you a higher risk. If you’re trying to improve your credit to get better interest rates in the future, you may want to consider a secured credit card, which is backed by a cash deposit that acts as collateral should you miss a payment.

Whatever type of credit card account you open, a key step to rebuilding your credit is to avoid missing any future payments and do your best to stay in good standing by paying on time. As your credit score improves, so will the credit card offers that you receive.

Why credit card APR can increase

Some credit cards come with low/no interest introductory periods. These rates are temporary by design and your APR will increase once the promotional period is over.

Your APR may also increase if you fail to follow the terms of your credit card agreement, most commonly by missing a payment. Each lender sets its own rules and guidelines. The agreement will list the APR for your account and the reasons why a credit card issuer can change the APR and/or charge fees.

If your APR increases, look at what your agreement says about violating the terms, such as making a late payment or not making a payment at all. Some lenders may reinstate your previous APR if you get your account current by making the minimum payment (or more) by the monthly due date for a certain period of time. With other lenders, the inflated APR may be permanent. If you’re not sure after reviewing your agreement, contact your credit company and ask.

How to manage a higher APR

If the increase in your APR is permanent, you have a few options:

  • Transfer the balance to a different account. If you have another credit card with a lower interest rate, you may be able to transfer the balance (for a fee). Read the agreement or call the credit company to ask what they can offer.
  • Open a new credit card that accepts balance transfers. Carefully review the agreement for the new credit card to be sure it offers a lower interest rate and that you understand the terms for the APR, fees, etc.
  • Pay off the balance and stop using the card. If you can’t bring down the APR, work to pay off the balance as expediently as you can. After that, just don’t use that card anymore. Canceling a credit card is one way to prevent future use, but keep in mind that closing an account, especially one you’ve had for a long time, may cause your credit score to drop because the age of your accounts is part of the calculation in most credit scoring models.

How to pay off multiple credit cards with different APRs

If you carry over balances every month or have hit your credit limit on more than one credit card, you’ll want to develop a strategy for paying off the cards and improving your credit.

Two popular strategies are known as “snowball” and “avalanche.”

To use the snowball strategy, begin by identifying the credit card with the smallest balance. Then follow these steps:

  • Pay the minimum amount due on your other credit card accounts.
  • Put anything extra toward repaying the smallest account.
  • Once the smallest account is paid in full, move to the next smallest account.
  • Use whatever extra you were paying on the first account toward the next one.
  • Continue working from smallest to largest until your biggest credit card debt is paid off.

The avalanche strategy takes a different approach by focusing on the credit card accounts with the highest APRs, which cost you more on a per dollar basis.

To use the avalanche strategy, start by identifying which of your credit cards has this highest APR. Then, follow similar steps as the snowball strategy:

  • Pay the minimum amount due on your other credit card accounts.
  • Put anything extra toward repaying the account with the highest APR.
  • Once the highest APR account is paid in full, move on to the account with the next highest APR.
  • Use whatever extra you were paying on the first account toward the next one.
  • Continue working from highest APR to lowest until all your credit card debt is paid off.

Many people working to get out of credit card debt find the snowball strategy to be more satisfying, in part because it creates more budget flexibility as each debt is repaid and those payments are no longer necessary. However, targeting high interest debts will save you money in the long run. You’ll need to evaluate your options and pick the approach that works best for your situation.

If your credit card bills are too much to handle

Unfortunately, the people whose APR increases due to a missed payment are often those who can least afford to have their rates go up. If your credit card payments are too much to handle, talk with an MMI credit counselor to see if a debt management plan (DMP) could help to get you out of credit card debt.

DMPs offer a structured repayment program in which you make a single payment to a nonprofit credit counseling agency (such as MMI) which disburses funds to your creditors on your behalf. Your creditors are often willing to work with a DMP and reduce your interest rate as you work to pay your debts. The average APR for accounts included on a DMP with MMI is less than 7 percent.

Begin an analysis of your debt online and see if a DMP is right for you.

Tagged in Debt strategies, Banking

Emanuel Rivero. Emanuel Rivero is Senior Director of the Hispanic Centers for Financial Excellence (HCFE). He specializes in the Latino financial experience in the United States, with a focus on helping newer residents understand, access, and engage the financial system.
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