Credit cards provide an effective and easy way to purchase goods and services. With a credit card, you can buy what you need and make your payments later. However, you may incur interest on the purchases you make with your credit card. The interest charges are set in once the due date on your credit card passes without you paying the loan in full. It is therefore important to understand credit card interest so that you can manage your card effectively. That will save you money on interest expenses.
Types of Interest Rates on Credit Cards
There are different types of credit card interest rates. The different types of interest affect the calculation of the charges against your credit card. Your use of the credit card determines the interest that you incur. Your monthly credit card statement usually states the current bank interest rates and charges applicable to your card.
- Purchase Interest RateThis is usually the main bank interest rate on your credit card. Your provider usually advertises this rate. You will incur interest on your purchases at this rate if you fail to pay off the closing balance by the due date or within the free-of-interest period.
- Promotional Interest RatePromotional interest rates are special interest rates that apply for a limited period. Normally, the provider gives the customer a period within which the customer enjoys lower bank rates. The low honeymoon interest rates usually apply immediately after opening a new card and end after the introductory period. The promotional bank interest rate can be as low as 0%, and last for up to 5 months.
- Cash Advance Interest RateYou may be able to make cash withdrawals with your credit card. However, cash transactions using your credit card attract a higher interest charge than purchases. The cash advance interest rate starts to apply the moment you make the cash withdrawal until when you pay back the borrowed amount in full. The cash advance interest rate is usually around 21%. Other than the interest on cash advances, you also need to note that the transactions attract a cash advance fee.
- Balance Transfer Interest RateA credit card balance transfer involves transferring an existing credit card debt to a new one at lower bank rates to pay it off. The balance transfer interest rate is the rate that applies when such a transfer occurs. Often, the interest rate will be 0%. However, the transfer interest rate only applies for a limited period of up to two years. If you do not pay off the debt in full by the end of the period, the interest rate reverts to the current cash advance bank rates.
Calculating Credit Card Interest Rate
The calculation of the interest on your credit card takes into account three key components.
- The Annual Percentage Rate
- The Daily Rate
- The Average Daily Balance
The annual percentage rate is the interest rate that is stated on the credit card. When you divide the APR by 65 days, you get the daily rate. For instance, if the APR was 14%, the daily rate would be 0.38%. The average daily balance is the balance in your account multiplied by the number of days in the month.
The formula to calculate interest on your credit card would be:
Interest = Daily Rate (%) × Average Daily Balance × Number of Days in the Month
Assume your purchases using your credit card were $2,000 for January and your credit card has an interest rate of 15%. That means that your daily rate would be 0.04% and the number of days would be 31.
Thus, your interest repayment for January would be:
Interest = 0.0004 × $2,000 × 31 = $24.80
The daily interest charge is added to the daily outstanding balance. That means that for each day that passes without you clearing off the amount owed, it grows by the daily rate. Thus, the longer you take to repay the amount, the more interest you will end up paying.
ASIC provides that the minimum repayment amount for loans is 2-3% of the outstanding balance or $20, whichever is higher. Therefore, you will be required to pay at least $20 or 2% of the outstanding balance every month.
When Your Credit Card Starts to Incur Interest
Each credit card has a due date. That is the date by which you are required to pay the amount owed in full. When you fail to pay the balance in full, the interest charge sets in and the balance starts to incur interest.
For most credit card facilities, the due date is the last day of the month. Thus, regardless of the date, you made your purchases, the interest charge will only start to apply when that day passes.
The Interest-Free Period
It is important to understand the terms of your credit card. An important aspect of the credit card is the interest-free period. This refers to the number of days your credit card provider allows have balances without incurring interest. However, once the period lapses, any unpaid balance would attract interest. You will have to pay interest on the purchases not paid off by the statement’s due date if the period days lapses without settling the balance.
Market data indicates that credit card providers allow a maximum of 62 interest-free days. However, on average, the period is commonly between 44 and 55 days. You need to understand how the interest-free credit card terms work for you to maximize it and avoid interest charges.
While credit cards may offer you a period within which you do not incur interest charges if you settle the amount in that time, that period does not start when you make the purchase. Rather, it starts at the start of your statement period. For instance, if your statement period starts on the first day of the month, the period would start at the start of the month. Thus, if you purchased on the first day of January using a credit card with 55 days free of interest, you will have 55 days within which to pay the amount and avoid interest. However, if you made purchases on the 20th day of January, then you will have 35 days to repay the amount without incurring interest.
Some credit card providers do not offer any free-of-interest days. Such cards are likely to be expensive to you. That is because there is an interest charge on all your purchases regardless of whether you clear your balance at the end of your statement period. Such cards usually have low-interest rates aimed at attracting customers. You should be careful when considering such cards to avoid huge expenses.
Avoiding Interest on Your Credit Card
Interest accrues due to two main reasons. First, you incur interest when you fail to pay the credit card balance by the due date or within the free-of-interest period. Secondly, your card starts to incur interest immediately after you take any cash advance on the card.
To avoid paying interest, you need to avoid doing things that attract interest. First, ensure that you always pay your closing balance by the payment period. When you settle the balance on your statements by the due date, you avoid paying interest on your purchases.
Since cash advances attract interest that is applicable immediately after you use the facility, you should avoid using cash advances to avoid interest. Unlike purchase interest rates, cash advance interest rates start affecting your balance immediately after you take out cash using your credit card.
You need to note that promotional purchases using interest-free may attract high-interest rates if you do not pay off the amount by the end of the promotional period. At the end of the promotional period, the outstanding balance on the promotional purchase will incur interest at the current cash advance rate.
Reducing Interest Payments
You may not always be able to pay off your balance in full. However, you should always strive to keep your interest payments as low as possible. That is possible through managing your repayments. You can keep your interest payments low by paying as much as possible. Since the calculation of interest is daily, the more you pay off, the less interest you will pay in total.
You should also pay attention to the allocation of repayments to your credit cards. Some providers apply repayments to the portion of your balance with the highest interest rates first, before portions with lower rates.
A balance transfer may be necessary if you have outstanding balances with several credit cards. The balance transfer will give you introductory promotional rates that are lower than the purchase rate. The balance transfer will also make it easy for you to manage your repayments, as you will only have to remember one repayment each month.
As you seek to use credit cards, it is important to assess and compare different credit cards to determine the one that meets your needs. Always evaluate keenly all key factors and pay attention to the terms by the providers. That way, you will avoid expensive interest charges.
*General Advice Warning – “Any financial advice provided by TaxReturn.com.au is general in nature and is not personal financial advice. It does not take into account your objectives, financial situation, or needs. Before acting on any information, you should consider the appropriateness of it regarding your own objectives, financial situation and needs.”