How Is Credit Card Interest Calculated?
Get the scoop on how credit card interest is calculated.
An anonymous podcast listener asks:
Do you only have to pay interest charges on a credit card if you carry a balance from one month to the next? Also, how does using a credit card help you boost your credit score?
This is a great back-to-basics question. If you don't really understand how a credit card works, it's easy to get into trouble using one.
Credit cards start charging interest the day you make a purchase, take a cash advance, or transfer a balance from another account. You're typically charged a daily rate that's equal to the card's annual percentage rate (APR) divided by 365.
For instance, the APR for new purchases could be 11.99%, cash advances 23.99%, and balance transfers 5%. The balance for each of these transaction categories accumulates each day until you pay them in full.
The good news is that credit cards give you a grace period for purchases (but typically not for cash advances or balance transfers) that allows you to avoid interest on new charges if you pay your balance in full by the billing statement due date. But if you carry all or a portion of the balance into the next month, the interest starts racking up. Additionally, if you make a late payment you're charged a fee that gets added to your outstanding balance--and yes, interest gets calculated on that amount too. Now, let's cover the second part of the question about building credit. Credit cards help boost your credit score in the following 4 ways:
- Paying your credit card bill on time allows you to build a positive payment history, which is the most important thing for raising your credit score.
- Charging no more than 30% of your available credit shows that you use credit responsibly.
- Owning a credit card for a long time extends your credit history, and the longer the better.
- Having a mix of credit accounts, such as installment loans, mortgages, and credit cards is a boost to your score.
A credit card is a very powerful financial tool that can enhance your life if you use it responsibly. On the other hand, abusing a credit card by making purchases that you can't afford to pay off in full each month, can be devastating for your financial future.