If interest rates were simple and straightforward, we’d probably talk about them less. But, that isn’t the case. There’s much to know and understand about interest rates if you ever plan to use a credit card or loan.
Most credit card issuers give you a grace period to pay your credit card balance in full before you'll have to pay interest in the balance. Any balance left beyond the grace period will be subject to interest. Interest on credit card balances is assessed in the form of a finance charge, calculated based on your credit card balance and your interest rate.
Finance charges are calculated in a variety of ways depending on your credit card. Some finance charges are based on your average credit card balance, the balance at the beginning of the billing cycle, or the balance at the end of your billing cycle. Finance charges may or may not include new purchases. Check out Six Ways Finance Charges Are Calculated for details.
There are two basic types of interest rates – fixed and variable. A fixed interest rate remains the same unless the credit card issuer sends advance notice of the change. Fixed interest rates can only change in certain circumstances, discussed more below.
Variable interest rates can change more often because they’re based on another interest rate, like the prime rate. Whenever the underlying interest rate changes, the variable interest rate also changes and credit card issuers don’t have to send notice of the change.
Several Different APRs
Credit cards that allow different types of transactions usually have different interest rates for those transactions. For example, a credit card may have a purchases APR, cash advance APR, and balance transfer APR. Each of these interest rates may be different. The penalty APR goes into effect when you default on your credit card terms, for example by making a late payment.
When you make a payment to a credit card that has different balances with different APRs, any amount above the minimum payment must go to the balance with the highest APR.
If interest were charged only on an annual basis, the APR would be all we needed to know. But, interest is most often paid on a monthly or other periodic basis. Credit cards also have a periodic rate, which is really just another way of stating the regular APR. The periodic rate for monthly interest is simply the APR divided by the number of months in the year, e.g. 18% / 12 or 1.5%. Periodic rates are more often based on a billing cycle shorter than one month. In that case, the periodic rate is calculated like this: (APR / days in year) * days in billing cycle.
The daily rate is another periodic rate calculated by dividing the APR by the number of days in the year.
Besides when default on your credit card terms, banks can only increase interest rates on your current balance at certain times: your variable rate increases, a promotional rate expires, or when changes are made to a debt management plan. Interest rate increases can be applied to new purchases as long as a 45-day advance notice is made.
If you receive an interest rate increase notice, you have the right to opt-out of the new interest and continue paying your credit card balance at the old interest rate. Your credit card issuer may decide to cancel your credit card if you opt-out, but you won’t have to pay the higher interest rate. To opt-out, simply send an opt-out letter to your credit card issuer within the opt-out period.
On most credit card balances, you can avoid interest by simply paying your credit card balance in full. With certain balances, like cash advances and balance transfers, it isn’t so easy to avoid paying interest because those balances don’t have a grace period.