Credit Card Interest Rates 101

So you just opened an envelope that contained a shiny piece of plastic with your name on it. Awesome … a bank or financial institution just gave you a line of credit! Before you start joyously swiping it on just about any cash register, take the time to read this article to understand the credit card interest rates.

A credit card is an authority to spend the money of the company that issued it, in return for a promise that you will repay them in the future, called payment-due date. This date is written on your card’s monthly billing statement together with the total cost of the items you purchased for that month (outstanding balance). Smart credit card users pay for the total outstanding balance on the payment due date. However, there maybe instances that you will not be able to. During these times, the card company let’s you borrow the money longer, until the next month’s payment-due date, for a fee. This fee is calculated based on the credit card’s interest rate.

Usually, credit card companies quote the APR (Annual Percentage Rate) as the “interest rate” for using their card. But, this is not entirely true. When you do not pay the total outstanding balance, interest is applied to it, called the monthly periodic rate (equals APR/12). This is added on to the unpaid amount and becomes next month’s outstanding balance. Every month, the periodic rate is applied to whatever outstanding balance is unpaid. This process is called compounding interest. So, the total of the compounding interest is the Effective Annual Rate (EAR), which is in-fact bigger than the APR. This is the TRUE interest rate of the credit card. Consult http://www.abcguides.com/creditcards/cci_faq.htm#interest for an illustrated example of the discussion above.

An introductory rate is an interest rate that is offered by a card company for a limited period (say 1st year of using the card). This is usually very low, sometimes 0% to attract you to apply. After the limited time, the EAR will be the on-going interest rate. Be sure to check this before signing up.

Also, ask whether your rate is fixed or variable. Fixed interest rate does not change from month to month. A variable interest rate changes monthly, based on some industry rate (for example, Fed Rate or Prime Rate) from which your rate is calculated (your rate is 5%+ Fed Rate). It may be smarter in the long run to choose a fixed-rate card.

Now that you have a better understanding on credit card interest rates, it is still wise to settle the total outstanding balance monthly. Else, pay only for what you can afford, as if you did not have the credit card.