Credit card companies make money in two ways – interest and fees. Federal law demands that all cards express their interest rate as an annual percentage rate (APR), which lets your compare ”apples to apples.” Typical credit card APRs hover around 20%, but the range is much greater, running from 0% to 35% and higher. Let’s get a better understanding of APR and then see how to keep your interest costs low.
Credit Card APR
The definition of APR is simple:
APR = Annual interest / principal amount
While the interest is annual, you are billed every billing cycle (typically 25 to 31 days). Moreover, almost all credit cards feature daily compounding of interest. To make sense of the APR you’ll actually pay, you need to understand two important concepts: compounding and grace periods.
Compounding is the way interest is applied to your balance, in this case, your credit card balance. Daily compounding is applied, well, daily. To do so, the card issuer calculates the Daily Periodic Rate (DPR) thusly:
DPR = APR / 365
For example, a 20% APR translates into a DPR of 0.054795%. To figure the interest you’ll be charged for the billing period, the card company does the following:
- Determines the end-of-day balance subject to interest for each day in the billing cycle.
- Calculates the average daily balance subject to interest for the billing cycle. That is, it sums all the end-of-day balances in the period and divides by the number of days in period:
Average Daily Balance = Σ(Daily Balances) / Days in Cycle
- Applies the DPR to the average daily balance:
Interest for billing cycle = DPR x Average Daily Balance
Note that we specified the end-of-day balance subject to interest. We need to qualify the balance amount this way to account for the card’s grace period.
Virtually all credit cards offer a grace period, which is a period in which you can pay off new purchases without being charged interest. In other words, you won’t have to pay interest on the amount of new purchases you repay within the grace period. A typical grace period is at least 21 days, starting from the last day of the billing cycle.
So, in a simple example, if you spend $500 on purchases during the billing cycle, you can avoid interest on the $500 by paying it off before the end of the grace period. For instance, if the cycle ends on the 3rd of the month and the grace period is 21 days, you avoid interest on purchases made during the cycle by submitting your payment by the 24th of the month.
Note that the grace period does not apply to balances that were unpaid as of the start of the period. Previous unpaid balances continue to accrue interest until paid. You should understand in advance the order in which the card company applies your payments. If it applies your payments first to your current purchases, your previous unpaid balance (and the interest on it) won’t be reduced until you first repay your current purchases. In the reverse case, your payments are first applied to your previous unpaid balance and then to your current balance.
How to Pay a 0% APR
You have two ways to pay no interest on your credit card balances:
- Every month, pay in full within the grace period. In effect, you will be using your credit card as a charge card, which allows you to avoid using cash or checks to make purchases without financing your purchases over multiple cycles.
- Take advantage of an introductory 0% APR offer, if any. This offer specifies a period from the opening of the account in which new cardholders aren’t charged for purchases. Once the introductory period expires, you’ll be charged the card’s normal interest rate.
Getting a Low Rate
Here are a few tips to keep your costs low:
- Use a secured card, in which you deposit collateral to guarantee your payments. A good APR for a secured card is around 10%.
- Improve your credit score to become eligible for low-interest unsecured cards, in which a good APR starts around 14%. You can improve your score by paying your bills on time and limiting the amount of credit you use.
- Use a debit card instead and avoid interest charges.
- Use credit cards that don’t charge an annual fee.