Getting your first credit card is very exciting. That little piece of plastic is a gateway to adulthood and, when used responsibly, can be your first concrete step toward establishing solid financial habits that last a lifetime. Unfortunately, however, many teens and young adults don’t know enough about credit card interest when they open their first line of credit (such as a credit card) and end up deep in debt, and quickly.
Don’t let this be you! Make sure you learn everything you need to know about credit card interest and how it works before you apply for your first credit card.
What is credit card interest?
Interest on a line of credit is the money the credit card issuer charges the cardholder to borrow money each time they use their credit card. The interest is usually set at an annual rate known as the annual percentage rate. APR Credit card companies use the APR to calculate the amount of daily interest the cardholder is charged for purchases, as well as the unpaid balance on the line of credit associated with the card.
Important credit card terms to know
Before you learn how credit card interest is charged, you’ll need to know some basic credit card billing terms:
• A credit card billing cycle is the period between credit card billings. Billing cycles can range from 20 to 45 days, depending on the credit card issuer. During that period, purchases, credits, and interest charges will be added to or subtracted from the balance.
• At the end of the billing cycle, you will receive your credit card statement, which will reflect all charges due during this period.
• The statement will also highlight the payment due date, which is typically approximately 20 days after the end of the billing cycle.
• The period between the end of the billing cycle and the payment due date is known as the grace period. If you do not pay your bill in full before the grace period ends, the outstanding balance will be subject to interest charges.
Calculation of interest charges
To calculate your interest charge for a billing cycle, follow this formula:
Step 1: Divide your APR by the number of days in a year to get your daily periodic rate, or the amount of interest your credit card issuer charges cardholders during each day of the billing cycle.
For example, if your APR is 18.5%, you would divide that by 365 to get your daily periodic rate of .0005%. (0.185 / 365 = .0005)
Step 2: Multiply the daily periodic rate by your average daily balance, or the balance you carry during each day of your credit card billing cycle, to get your daily interest charge. To find your average daily balance, look at your credit card bill. You can also determine your average daily balance by taking the sum of the balances at the end of each day in the billing cycle and dividing that number by the total number of days in your billing cycle.
Using the numbers from the example above, if your average daily balance is $1,200, you would multiply this number by your daily periodic rate (.0005%) to get a daily interest charge of $0.60. (0.0005 * 1200 = 0.60)
Step 3: Multiply your daily interest charge by the number of days in your billing cycle.
Continuing with the example above, if your billing cycle is 30 days, you would multiply $0.60 by 30 to get an interest charge of $18 for this billing cycle. (0.60 * 30 = 18)
Avoid paying interest
Credit card issuers will only charge interest if you carry a balance from one month to the next. If you pay your balance in full before the grace period ends, no interest will be charged. It’s a good idea to familiarize yourself with the payment due date in your credit card billing cycle and set a reminder to pay your bill before the due date whenever possible.
If you have a large outstanding balance and it’s not possible to pay it off in full at the end of the billing cycle, at least try to pay more than the minimum payment each month. It’s also a good idea to avoid charging more purchases to your card if there is already an unpaid balance. Remember: A credit card purchase that isn’t paid off by the payment due date can mean paying for that purchase for months, or even years, to come.
Credit cards are a necessary part of life. Building a strong credit history can open the door to long-term loans and other financial opportunities, but not learning how credit card interest works can lead to a spiral of debt. Before you open your first credit card, brush up on your understanding of how credit card interest works and how it affects you as a cardholder.