How credit card interest works

Most people know credit card users are charged interest on unpaid balances, but not everyone understands what interest is.

If you never carry over a balance, you might never need to know how interest works. But if you ever don't pay the full amount owed, even for just for a month or two, it's wise to know how interest is calculated and how it adds up.

Some transactions get a grace period -- some don't

  1. Purchases.
    Interest does not start applying to purchases immediately. You typically get 21 to 28 days to pay off a purchase without interest, says Wendy Dupuis, executive director of Financial Fitness. This period may be longer if you get a lengthy 0 per cent interest introductory offer. This grace period is spelled out in your credit card agreement's terms and conditions, or you can call your card issuer to ask for details.

    how-does-interest-work What people often don't understand about credit cards is that "there's no free ride," says Brian Betz, debt counsellor with Money Mentors. If you don't pay off the balance in full, "then the interest goes back to the date that you incurred the debt."

    Even if you make a payment covering half the purchase price on your due date, you will pay interest on the full amount. Why? Interest is calculated on the average daily balance -- even though the interest rate usually is shown as an annual percentage rate.

    For example, let's say you buy a $500 TV on the first day of your credit card cycle, and you pay $250 on the due date (21 days later). If your interest rate is 19 per cent, then you will be charged roughly $5.47 in interest.

    How did we come up with that figure? To calculate your daily percentage rate, divide your annual percentage rate (19 per cent) by 365. The result, in this case is a daily percentage rate of 0.05205. At the end of each day, the card issuer multiplies your current balance ($500) by the daily rate to come up with 26 cents of interest per day. Multiply that by 21 days and you get $5.47.

    Here's the math: Average daily balance x Daily interest rate x Number of days = interest charged: $500 x 0.0005205 (19%/365 days) x 21 = $5.47

    This is a simplified example, as most credit cards charge compound interest, meaning you are charged interest on your interest. "The odds are stacked against you," says Betz.

    Of course, if you pay the entire $500 amount of the purchase before the due date, you will not be charged any interest.

  2. Cash advances.
    Cash advances do not get the same grace period as purchases, says Dupuis. With a cash advance, interest applies from the day you withdraw the cash, and it's often very high, making a cash advance a very costly move. For instance, while the average purchase APR is about 19.9 per cent in Canada, most credit cards charge about 22.9 per cent interest on cash advances.

  3. Balance transfers.
    Balance transfer interest is often higher than usual, too. The exception is if you apply for a balance transfer card with a 0 per cent interest introductory offer. Even if this is the case, Betz says there are risks and costs involved.

    A 0 per cent interest balance transfer "is a loss leader," he says. "They're giving you this deal to get you the account. At the end of that interest-reduced period, what happens?"

    The answer: often, you're left paying a very high interest rate, typically around 21.99 per cent.

    Something else to note: Many balance transfer cards have that 0 per cent interest only on the transferred balance -- not new purchases or cash advances.

    "Your balance transfer is generally the only thing that is at that reduced rate, and any new charges that are accrued on that card will be at the higher contracted rate of that card," Betz says.

    Also note: don't miss a payment on your promotional balance transfer card, and don't pay late. That will void your 0 per cent interest plan, and you'll be charged the card's regular interest rate on the balance you transferred.

How much of your payment goes toward interest?
Another thing to keep in mind is how your payments are allotted. Interest is always paid first. For instance, take the example of the $500 purchase in which you paid $250 by the due date. Your payment was applied first to the interest charges of approximately $5.47, so you actually paid only $244.53 of your principal.

Credit card issuers can choose how they apply the remainder of your payment. They may choose to apply it to the highest-interest charges on your account, such as a cash advance, or they may apply it proportionately to all charges. The method used should be disclosed in the terms and conditions that came with your card.

"The bottom line is, you're still paying money from the day you incurred the debt if you don't pay off your balance each month," Betz says.

So pay off your balance every month. If you can't, Dupuis and Betz both recommend paying more than the minimum payment. Indeed, pay as much as you can of what you owe -- to minimize what you'll pay in interest.

If you take a look at your credit card statement, you'll see that your card issuer discloses how long it will take you to pay off your balance in full if you pay only the minimum payment. Depending on your balance, you might find it shocking.

The minimum requirement for how much of your minimum payment must go toward the principal has never been very high, and it has been reduced in recent years, Dupuis says. "It used to be 3 per cent. Now it's 2 per cent."

Looking back at the $500 purchase example, your minimum payment would be $10 ($500 x 2%). You were charged about $5.47 in interest, so if you make only your minimum payment, less than half of that ($4.53) was applied to the principle. You'll still owe $495.47.

At that rate -- making only your minimum payments every month -- it would take you 100 months or 8.3 years until you have paid off the $500 for that TV. And you would have paid $498.52 in interest.

Missed payments can increase your interest
Everyone has financial struggles. If you're having a rough month, you might be tempted to just skip it, and pay more next month. Don't do that.

"A lot of people don't understand that once they miss a payment, that interest rate can actually increase," says Dupuis. Check out the fine print that came with your credit card. Your interest rate could increase by 5 per cent if you miss a payment, and it could stay at the increased rate for several months.

In addition, missed payments are reported to the credit bureaus and will lower your credit score. Payment history makes up the largest part of your credit score.

Bottom line: interest makes carrying a credit card balance an expensive way to borrow money.

 A simple rule of thumb: credit cards can be useful for short-term emergencies, Betz says, "but then you focus on paying it back and getting it back to zero."

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Updated: 03-26-2019