How does a credit card rate of interest work?

credit card rate of interestCredit cards usually have several different interest rates, although each work in a similar manner. One of the most talked-about interest rates is the APR, or annual percentage rate, which is typically the rate charged for balances due on purchases using the credit card.

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You can actually avoid paying the purchase APR if you pay off your balance due in full every month, instead of just paying off the minimum amount due. That does not mean, however, percentage rates are not an important aspect when choosing a credit card just in case you ever do have to make interest payments.

How Purchase APR Works

There are two types of annual percentage rates, the Federal Reserve explains, a fixed rate and a variable rate. Fixed rates are those that remain steady for a specified duration noted in your credit card agreement. After the duration expires, credit card companies can change your interest rate as they see fit unless that is also outlined in the agreement.

A change in interest rates usually comes with an advance notice in writing from the credit card company.

A variable credit card rate, which is more common and changes with the index used to create it. Credit card companies pick an index over which they have no bearing. Common indexes companies use are the Treasury bill rate or the prime rate.

The Treasury bill rate is the rate the government pays when it borrows money for a short period. The prime rate is the rate charged by most banks at any given moment. As the Treasury bill rate and prime rate rise and fall, variable credit card interest rates rise and fall along with it.

Purchase annual percentage rates are usually those charged for balances due on purchases using the credit card, but only if the balance is rolled over from month to month. If you have $100 balance due and your interest rate is 10%, for instance, your new balance due will increase to $110.

If you continue to roll over a balance due every month, an additional 10% interest rate will continue to accrue every month on balance of the original purchase as well as the balance on the interest. Add new purchases to the mix for which you also carry a balance, and they, too, will be subject to the APR unless you pay off your full amount every month.

The APR, as noted, usually applies to new purchases. Other transactions can carry different interest rates on the same credit card.

Other Credit Card Interest Rates

credit card rate of interestThe purchase APR applies to new purchases on the card, and other types of APRs apply to other transactions, notes the Federal Reserve. A balance transfer APR can apply to moving a balance due from one credit card to another. It can also come with a separate balance transfer fee.

A cash advance APR applies to cash advances taken from the credit card. Both balance transfer and cash advance APRs are usually higher than the purchase APR. They may be based on the same formula used to determine the purchase APR but carry a higher rate.

A very low or 0% introductory APR may also be part of a credit card agreement. This is a reduced rate offered for a limited time to new customers to urge them to try out the credit card. The duration of the period and your APR after the period expires should be noted in the credit card agreement.

Penalty Interest Rates

Penalty interest rates can be especially dangerous since they can be very expensive and stay in place until the credit card company decides to remove them. Penalty rates can also apply not only if you make a late payment on the particular credit card that charges the rate, but for other reasons as well.

PBS warns credit card companies can impose the penalty interest rate if you are late paying off any bill, even if it has nothing to do with your credit card. This can apply to late car payments, late mortgage payments or even late utility bill payments. PBS says the credit card issuers can use the excuse that they believe the late payment illustrates how you have accrued too much debt.

The penalty interest rate is supposed to encourage you to pay off your credit card bills on time to avoid paying the extremely high penalty rates.

Your credit card agreement outlines the penalty interest rate and when it can be applied.

Reviewing the entire credit card agreement before signing on the dotted line is always a good idea. This can help you avoid costly penalty APRs and better budget your money to reduce your overall interest payments.

Finding a credit card with a low APR can also help, so a look for one now with our FREE credit card chaser!

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