How Credit Card Interest Rates Work
When you are comparing credit cards one of the first things you will see advertised is the “APR”. APR simply means the annual percentage rate and is the amount of interest that will accumulate on your balance for an entire year. The way it works is that every month you will be charged interest on whatever you have owning, commonly called your “balance” and that interest rate will add up to the APR by year’s end. For example, if you only use your credit card once and spend $2,000 and don’t make a payment for one year, at an 18% APR you will have paid an additional $360 by the end of the first year. Here’s the formula:
Balance x Interest Rate % = $ Interest Charged
Now keep in mind this is a very simple formula but in the real world things get a lot more complicated as one doesn’t usually just use their credit card once a year. Nor do most people pay off their credit card in the first year. Let us see what would happen if we didn’t pay off that $2,000 until five years later.
Year 1 = $2000 x .18 = $360
Year 2 = $2360 x .18 = $424.80
Year 3 = $2784.80 x .18 = $501.26
Year 4 = $3286.06 x .18 = $591.49
Year 5 = $3877.55 x .18 = $697.95
Total Balance = $4575.70
I hope I haven’t lost you. But as you can hopefully see by the end of year five, your credit card balance where you only spent $2,000, is now $4,575.70. That’s a 128% increase! The point of all this is that it is not only important you get a low interest rate but that you pay off your credit card balance as much as you can and do not let it sit and accumulate interest.
You may also notice that it will be advertised as “APR as low as…”, this because the interest rate you will be charged will be based on your credit score. Simply put if you have no credit history or have a low credit score because you have taken out loans and not repaid them on time then your APR will be higher (and vice versa).
If you have taken the effort to manage your finances from day one than it is possible for you to pay no interest on your credit card as you can pay off your credit card’s balance in full every month. This not only saves you from having to pay interest fees but also increases your credit score dramatically.
