Credit cards are a two-sided coin. On one hand, when used responsibly, they are a great tool for building credit. They can also be a great budgeting tool, helping you finance a large purchase over time, sometimes interest-free.
On the other hand, credit cards can put consumers in debt, when they aren’t used responsibly. With the purchasing power of a credit card in hand, it’s easy to make more purchases than you can afford to pay off when the bill comes.
Let’s talk about the cost of credit card interest, how it works and how to avoid having to pay it.
What Is the Grace Period?
Most credit cards offer a grace period. This is a window of time during which you can pay off your purchases interest-free. The grace period usually lasts for 21 to 25 days. Credit card issuers are not required to provide a grace period, so you’ll need to read your card agreement to determine whether your credit card offers one and for how long. You also can find this information on your monthly statement.
For example, say you use your credit card to pay $37.50 for a meal on February 20. The statement closing date is March 3 and you see the charge on your statement. You have no other unpaid balances. The payment due date is March 28. You pay off the $37.50 on or before March 28, and your account is paid in full. On your next statement, you don’t see any interest charges and your beginning balance is $0.
Note that the grace period starts on the day the billing cycle ends, not on the date you make the purchase. Purchases made right after the billing cycle begins enjoy an even longer interest-free period.
When Does the Grace Period Apply?
You’ll only get the benefit of a grace period when you have no outstanding balance from the previous billing cycle. When you carry a balance, you pay interest on all new purchases from the date of each transaction. You cannot pay off new charges interest-free while you pay down prior debt.
This is an important detail to understand if you are considering a balance transfer offer. There are many credit cards available today that offer 0% interest on balance transfers for a specified period of time. If you transfer a balance, you can pay it down interest-free until the introductory offer expires, but you’ll pay interest on any new purchases you make with the card from the date of each transaction (unless the introductory rate also applies to purchases).
If you’ve lost your grace period, you can get it back, but you may experience a lag between when you pay off your card and when the grace period kicks back in. You may have to pay off your charges for two consecutive months or longer before you regain the benefit of a grace period.
Some transactions don’t have a grace period at all. Convenience checks and cash advances are two types that generally incur interest from the date of the transaction, even if you have no outstanding balance on the card.
How Does My Interest Rate Work?
If you are not able to pay off your balance by the payment due date and it becomes subject to interest charges, this is what you should know: You will pay interest fees. But how much? That depends on your Annual Percentage Rate (APR) or the rate of interest you will pay over the course of one year. Even though it’s an annual figure, most credit card issuers calculate interest monthly, based on your average daily balance.
In very simple terms, that means if you owe $1,000 and have a 15% APR and you make no payments, you’ll owe more than $1,150 at the end of the year. Interest is added each month, and then the following month’s interest is calculated on the new, higher amount.
Credit card issuers use different methods for calculating your interest charges, but here’s how it often works: First, figure out your average daily balance which is the sum of your balances on each day of the billing cycle divided by the number of days in the cycle.
So, let’s say you have a $50 balance from last month (no grace period for new purchases) and you add a few new purchases to your balance throughout the month and the sum of the daily balances is $5,740.12. Divide that number by the number of days in the billing cycle (30) and the average daily balance is $191.34.
Next, calculate the daily interest rate. So, your 15% APR divided by 365 days in a year is 0.041. This is a percentage, so we’ll move the decimal two places to the left.
From here, you take your daily balance ($191.34) and multiply it by your daily rate (.00041), multiplying this amount by the number of days in the billing cycle (30): You will pay $2.35 in interest charges for the current month.
If you make a minimum payment of $25, you’ll only reduce your balance by $22.65. The rest of your payment goes to interest.
Some credit card issuers calculate interest daily. This may result in slightly higher interest charges, but the difference is usually not significant. In this example, you would pay about $0.01 more.
Interest charges increase the cost of everything you buy with your credit card. One of the best things you can do for your financial health is to avoid charging more than you can already afford to buy. That way, when the bill comes, you’ll be ready to pay it off completely, avoiding the loss of your grace period and the interest charges that add up as a result.