If you’re like most people repairing their credit card debt, your credit card’s annual interest rate is a mystery to you. You might even avoid thinking about it or looking at it, because it’s such a large number. Interest rates can make it difficult to get out of debt quickly, because you’re working against a large percentage—as much as 16% or even 20% annual interest.
Credit card interest is calculated using a complicated formula that can be confusing to many people. So it often remains a puzzle to borrowers. But it’s important to understand the basics of credit card interest, because it will help you to repair your credit card debt quicker—and to be a smarter credit card user. Here’s how credit card interest works.
How Is Credit Card Interest Calculated?
If you’ve watched your interest rate closely, you may have noticed that it has changed since you first opened your credit card. Many credit cards offer a low introductory interest rate that increases after the period is over. But even after that, your annual interest rate will often go up and down. That can be confusing, and even a bit unsettling.
Your interest rate changes
The first thing you should understand is that your credit card uses a variable interest rate. That means that the interest rate can change over time. A variable rate is tied to a base index—usually the U.S. prime rate. As the U.S. prime rate goes up or down, so will your credit card’s interest rate.
Right now, the U.S. prime rate is 4.25%. But your credit card’s interest rate is probably closer to 18.25%, or even more. That’s because credit card companies charge an additional amount above the U.S. prime rate—perhaps 14%, but it varies from card to card. So your total interest rate will be closer to 18.25%, annually. If the U.S. prime rate raises or lowers, your annual interest rate will also go up or down by the same amount.
The factors that influence the U.S. prime rate are reviewed every six weeks. The prime rate could stay the same for years, or it could change every six weeks. It all depends on current federal economic conditions and forecasts.
Your interest rate is annual
It’s also important to understand that your credit card’s interest rate is an annual rate. So if your annual rate is 18.25%, that amount is applied per year—not per month. But since you’re billed monthly, your interest is calculated each month, using an average daily balance method.
Calculating your interest rate
Here’s how the average daily balance works:
- Determine the daily periodic rate (DPR)—the interest rate you pay each day. DPR is your current interest rate (it varies, remember) divided by 365. So, 18.25 / 365 = 0.05%.
- Determine the average daily balance for the month. This is done by adding up the balance for each day of the billing period, then dividing that sum by the number of days (either 30 or 31 days—or 28 in February!). If you had a balance of $0.00 for 10 days, then $500.00 for 10 days, then $1000.00 for the last 10 days of the month, your average daily balance would be $500.00.
- Multiply the DPR by the number of days in the billing cycle, then multiply that total by the average daily balance. This is your interest for the month. So, a DPR of 0.05% * 30 days = 1.5%. 1.5% * $500.00 = $7.50.
That might not sound like much, but if you’re an average cardholder in the United States, you’re carrying a credit card debt of $16,000.00. That means you’re paying $2,880.00 per year in interest alone, in this scenario.
How Can I Avoid Paying So Much Interest?
When you’re working hard to repair your credit card debt, it can be frustrating to be fighting against a high interest rate. But there are ways you can reduce—or even eliminate—the amount of credit card interest you’re paying each month.
Pay more than the minimum balance due
Your credit card statement lists a minimum amount that you must pay each month. Your interest for the month is rolled into that minimum payment. But if you pay more than the minimum, every dollar above that minimum goes towards your principal balance. There’s no interest charged on it.
In other words, if your minimum payment is $500.00 and you pay $600.00, that extra $100.00 is applied to the amount you borrowed—it’s interest-free. And that benefits you in two ways:
- You’re paying off debt without paying interest
- You’re lowering the dollar amount of interest you’ll have to pay next month, because your average daily balance will be smaller.
Open a balance-transfer credit card
A balance-transfer card can be a very helpful way to repair your credit card debt. A transfer credit card has a very low introductory interest rate—often as low as 0%. The card lets you transfer your balance from other debt onto the new card. You can then make monthly payments on the transfer card to pay down your existing debt.
But the low interest rate is only valid for a limited time—usually six to 18 months—so you’ll need to pay off the debt before the introductory rate expires. You should also do your homework: some transfer cards charge a transfer fee. And some charge a penalty APR, which allows the credit company to charge you a high interest rate if you miss a payment.
Pay off Your Credit Card Debt Faster
Your credit card’s annual interest rate doesn’t have to be a confusing mystery, and you don’t need to know everything there is to know about interest rates. But when you understand the basics of variable interest rates and how they’re calculated, you can use that information to repair your credit card debt faster and easier. Paying more than the minimum balance due and using a balance-transfer card can be very helpful ways to use interest rates to your advantage.
A reputable credit repair specialist can help you find other ways to successfully get out of credit debt. If you’re tired of struggling on your own, find out how our advisors can help you repair your credit debt. Contact us today.