How Does Credit Card Interest Work?

Do you read your monthly credit card statement? Most people are used to glancing at the balance due, but your monthly statement shows more than just your recent purchases and how much you owe. Your statement also shows the interest that applies to your account. 

Understanding how interest works can help you make smarter decisions about your money and avoid paying more than necessary. Let’s break down the math behind credit card interest in simple terms. 

What is credit card interest?

When you use your credit card to make a purchase, you borrow money from the card issuer. Credit card interest is the cost you pay to borrow that money if you don’t pay your full balance by the due date. If you pay off your full balance during the grace period (the time between when your statement closes and when your payment is due), you’ll be able to make interest-free purchases.

Your financial institution typically sets your credit card’s interest rate based on the prime rate—the baseline number based on the federal funds rate set by the Federal Reserve. This rate is shown as an Annual Percentage Rate (APR). This number tells you how much interest you’ll pay over a year. Different cards have different credit card interest rates, and your APR depends on factors like your credit score and the type of card you have. A higher APR means you’ll pay more when you carry a balance.

How is interest calculated on a credit card? 

Understanding how to calculate credit card interest can help you see where those statement charges come from. Let’s break down the process into a few simple steps.

1. Find the periodic rate

First, you need to know your periodic rate, which is typically expressed as a daily or monthly rate. This is how the financial institution determines what to charge you on a daily or monthly basis. Most credit cards have a daily periodic rate. To find the daily rate, take your APR and divide it by 365. For example, if your APR is 24%, your daily rate would be about 0.066%.

2. Calculate average daily balance

Next, your average daily balance is calculated. They take your outstanding balance at the beginning of each day, add any new purchases, subtract any payments and divide the balance by the number of days in your billing cycle. 

3. Determine the credit card interest rate

Your credit card interest is calculated by multiplying your periodic rate by your average daily balance.

Average Daily Balance × Monthly Periodic Rate = Interest Charge

For example, if your average daily balance is $1,000 and your daily periodic rate is 0.066%: $1,000 × 0.00066 = $0.66 in interest charges each day. This means if you carry a $1,000 balance for the entire 30-day billing cycle, you’d be charged $19.80 in interest for that month.

When do credit cards charge interest?

Credit cards charge interest at different times depending on the type of transaction. Understanding these timing differences can help you avoid unexpected charges on your credit card bill. Here are some factors to consider:

• Purchases: For most credit cards, purchases come with a grace period. This is the time between your statement closing date and your payment due date. If you pay your full statement balance by the due date, you won’t be charged interest on those purchases. But if you only make a partial payment, interest will start accruing on the remaining balance.
• Balance transfers: Balance transfers typically start accruing interest from the day they post to your account unless you have a promotional 0% intro APR offer. With this promotional rate, you won’t pay interest during the promotional period as long as you make your minimum payments on time.
• Cash advances: When you take out a cash advance (getting cash from your credit card at an ATM or bank), interest starts immediately. There’s no grace period for cash advances, so you’ll start paying interest from the day you get the money until you pay it back in full.

Knowing when interest begins can help you make smart decisions about when to make payments—and how to use different features of your credit card.

Are multiple interest rates applied to your account balance?

Yes, your credit card might have different interest rates (including variable interest rates) for different types of transactions. This is common and helps explain why you might see multiple interest charges on your statement.

Here’s how different transactions are typically charged.

How are payments applied to your account?

The way your credit card payments get applied to your balance can affect how quickly you pay down your debt. For some credit cards, your minimum payment first goes toward interest charges and fees. Then it’s applied to the balance with the lowest APR. 

Any amount you pay above the minimum gets applied differently—it first goes to the balance with the highest APR, then works its way down to the lowest. Within each APR category, your payment follows a specific order: interest charges first, then fees, followed by previous cycle transactions and finally current cycle transactions.

What happens if you only pay the minimum payment?

Making only minimum monthly payments on your credit card can significantly extend the time it takes to pay off your balance—and increase the total amount you pay. For example, if you have a $5,000 balance with a 9.9% APR and only make minimum payments, it could take you about 16 years to pay it off. During that time, you’d pay over $8,104 in total—more than $3,000 in interest alone!

Even making modest increases to your payment amount can make a big difference. If you paid a fixed amount of $125 each month on a $5,000 balance with a 9.9% APR, you could pay it off in about 4 years. You’d also save around $2,000 in interest by paying more than the minimum.

*The minimum payment percentage shown is an example only. The actual percentage may vary by financial institution.

6 tips for avoiding credit card interest

Managing your credit card wisely can help you minimize what you pay (or avoid paying interest entirely). Here are some effective strategies:

1. Pay in full: The simplest way to avoid interest is to pay your entire statement balance by the due date. This takes advantage of the grace period that most cards offer for purchases.
2. Pay on time: Late payments can trigger penalty APRs and late fees. Set up automatic payments or calendar reminders to minimize your chance of missing a due date.
3. Choose the right card: Look for cards with lower APRs, especially if you occasionally carry a balance.
4. Consider balance transfers: If you've incurred high-interest debt, transferring it to a card with a low or 0% intro APR can save you money. Just be aware of balance transfer fees.
5. Use balance transfers strategically: When using a balance transfer offer, plan to pay off the balance before the promotional period ends.
6. Negotiate your rate: If you’ve been a good customer with on-time payments, ask for a lower rate. NFCU doesn't offer rate reduction, but other financial institutions might.

Keep your credit cards on track

Understanding credit card interest can save you money, make full use of rewards and help you manage credit card debt wisely. Always try to pay your full balance by the due date to avoid interest completely. If that’s not possible, pay more than the minimum to reduce your balance faster.

Navy Federal Credit Union members can use Bill Pay to conveniently manage all their credit card bills in one place, and My MakingCents provides helpful tools for tracking expenses and creating a budget. By keeping your balance low and making strategic payment decisions, you’ll be on your way to better financial health.