Important Credit Card Concepts

September 04, 2018

Compounding interest

When do you have to pay interest? Most credit cards offer a one month grace period to pay off your balance. If you pay any amount less than the total debt (which many people often do by choosing the “minimum payment due” option), you’ll automatically be charged interest on the remaining balance.

Compound interest can be both a blessing and a curse. In the case of savings accounts and other interest-bearing investments, you earn compound interest—it works in your favor to multiply your wealth. With credit card debt, you pay compound interest, and thus it works against you to multiply your debt. Here's how it works: charges are added to the amount originally owed—also known as the principal—causing the debt to compound and grow exponentially. For example, let’s say you have a $500 debt that accrues 10% interest each month. In the first month after the grace period, you’ll get charged $50 in interest ($500 x 0.10). In the second month, that same interest rate is applied to your new total amount of debt ($500 + $50 = $550). Thus your next interest charge is $55 ($550 x 0.10), bringing your new total owed to $605. And so on, and so forth, in a never-ending unhappy cycle.

APR

You’ve probably heard the term APR—annual percentage rate. (Banks are legally required to display a card's APR prominently on any advertisement, so it's all over the place on billboards, magazines, and TV ads.) Your card's APR represents the approximate percentage you’ll pay in interest throughout a single year. The actual amount that you’ll pay is often even a bit higher than what the APR would indicate because most credit cards compound interest on a daily basis.

Keep in mind that you'll only be subject to an interest charge if you carry a balance, in other words fail to pay off your credit card bill in total at the end of each billing period. If you always pay off your card each month, you'll never be affected by your card's APR.

So how are APRs determined? It boils down to three main factors:

The prime rate

The prime rate is a baseline interest rate that is tied directly to the federal funds rate—the rate banks pay to borrow from the Federal Reserve. Unless you're chair of the Federal Reserve, the prime rate is outside of your control, but its fluctuations will influence your credit card's interest rate slightly.

Your credit score

This is the most significant factor in determining your APR. It's the bank's metric for determining how likely you are to pay them back. In short, the higher your credit score, the lower your interest rate will be.

Promotional offers

Promotional offers can be the wildcard of interest-determining factors. In an effort to entice customers to sign up for cards, companies will often offer appealingly low interest rates for a limited grace period (ranging anywhere from 6 to 24 months). A promotional offer can be as low as 0%. Be very careful with such offers—if you have any outstanding balance at the end of the promotional period, they will often retroactively calculate interest from the beginning of the period, saddling you with an enormous interest charge.

Paying your credit card bill not only has an impact on your credit report and score, but can also have an effect on the interest rate of all of your credit cards (not just the one that you’re paying). This is why it’s important to pay your monthly bill on time to avoid having your rates raised.

Encyclopedia of fees

In addition to interest charges, there are a number of fees you may encounter as a credit card owner. (Fees are typically distinguished from interest charges in that fees are fixed amounts, whereas interest is calculated as a percentage of your outstanding balance.) Some fees are inevitable, while others are easily avoided. Here are the most common types:

  • Late payment fee: You'll get slapped with a late payment fee if you fail to pay the minimum balance at the end of your billing period. (Note: you may be able to get a late fee waived by calling your credit card company immediately and explaining the circumstances.)

  • Returned payment fee: You'll get charged a returned payment fee if you attempt to pay your credit card bill and have insufficient funds (whether through a bounced check or a blocked automatic bank account payment). This fee is typically about $35.

  • Balance transfer fee: A balance transfer fee results from transfering the outstanding balance from one credit card onto another in order to avoid impending interest fees. This fee is typically between 3% and 5% of the amount transferred.

  • Annual fee: Many cards that offer generous rewards charge an annual fee. You can think of an annual fee as the price of admission to a VIP lounge with nice perks like cash-back on purchases, miles, discounts at select restaurants, and more.

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