Credit Card Interest

    Credit Card Interest with many cardsInterest rates and credit cards have a powerful — and potentially explosive — relationship in the U.S. economy.

    Interest rates are the economic fuel that drives credit card companies. It allows them to almost casually extend loans every day to the 175 million Americans who own at least one credit card.

    Interest rates are also the price consumers pay for the privilege of borrowing money — with certain spending limits — and make purchases whenever the mood strikes them.

    The two can be a dangerous mix.

    Credit card companies make a sizeable amount of money off the interest on unpaid balances. Visa, the largest credit card company, had a 43% profit margin on sales revenue of $12.7 billion in 2014. MasterCard, the next biggest credit card company, had profit margins of 38% on $3.6 billion in net income. Those profit margins are twice the average of the rest of the financial services industry.

    Cardholders provide the support system that made those profits possible. The Federal Reserve Board says credit card debt went over $900 billion in 2015. Also, Statistic Brain says 56% of consumers carried an unpaid balance from month-to-month, meaning they owed interest on their next bill.

    The average interest on those unpaid balances in 2015 was 15%, but cardholders who don’t pay off the balance at the end of every month face rates in the 25%-and-higher range.

    So obviously if you’re using credit cards — and not paying off the balance at the end of each month — you should know how interest rates affect your bill.

    Factors That Determine Interest Rates

    Interest rates can come in all sizes, but for credit cards they generally fall into one of three categories: variable rate, fixed rate and promotional rate. Most companies issue cards tied to revolving credit. Users of these cards are allowed to carry a balance on their accounts at the end of every billing cycle. Cardholders who carry a balance will see an interest charge on their next bill.

    There are four major credit card companies — Visa, MasterCard, American Express and Discover — and several factors that go into the interest rate charged on each of their cards.

    Among the factors:
    • Prevailing interest rates – Also known as “prime rates,” these provide the basis for most credit card rates. Prime rates were flat for years, but went up 0.25% in December 2015 and credit card interest rates went up with them. Cardholders paid an estimated $192 million more per month in interest based on that small change in the prime rate.
    • User’s credit history and card issuer’s risk evaluation – Credit card companies will look at both your credit report and your credit score to help them determine the interest rate. High credit scores mean lower interest rates and vice-versa.
    • Interest calculation methods – The popular term for calculating interest is APR (or annual percentage rate), but a single card may have several APRs attached to it. There could be different APRs applied to purchases, cash advances, balance transfers and promotion rates. Some cards have APRs that change after six months or one year.  Most have variable APRs, but a few are fixed.
    • Promotional offers – Card companies will entice consumers with offers of zero-percent interest, sometimes for more than one year. When the promotional period ends, rates go up.
    • Payment history – If you are late with payments or fail to pay altogether, card companies will increase your interest rates, sometimes dramatically.

    Calculating APRs

    There is a line on your monthly billing statement that tells you exactly what interest rate you pay on your credit card, but figuring out how they arrived at the total cost for that can be tricky.

    For one thing, the term “annual percentage rate” is a misnomer. Interest rates on credit cards are calculated on a daily basis and not an annual basis. And since most cards are based on variable interest rates, the numbers could change as the prime interest rate changes.

    The mathematical formula used to calculate monthly interest charges is the same for most card companies: average daily balance x periodic daily interest rate x number of days in a billing cycle.

    The average daily balance is the sum of all your purchases in a billing cycle, divided by the number of days in that billing cycle. The periodic daily interest rate is the APR assigned to your account, which is then divided by 365. Depending on the card, the number of days in a billing cycle can vary from 20 to as many as 45 days, but one-month cycles (30 days) are the norm.

    So, for example, if you charged $1,000 on your credit card that has a 15% APR and a 30-day cycle and didn’t pay a thing (or charge anything) by the time the payment was due, your interest charge for that month would be $40.99. It’s calculated this way: average daily balance ($1,000/30 = $33.33) x periodic daily interest rate (15/365 = .041) x number of days in a billing cycle (30). That would be 33.33 x .041 x 30 = $40.99.  

    Avoiding Interest

    There is really no secret to avoiding interest payments on credit cards: pay off the balance every month! There never will be an interest charge if you do that every month.

    Unfortunately, that is not how most people handle their credit cards. Depending on which survey you trust, as many at 56% (Statistic brain) and as few as 33% (National Foundation for Credit Counseling) of cardholders carry a balance from month-to-month and thus are subject to interest charges.

    There are some short-term ways to avoid interest:
    • Set up an online account at your bank to automatically pay your credit card balance from your existing checking or savings account. This presumes, of course, that you have enough money in your bank account to handle the monthly credit card bills.
    • Find a promotional card offer for zero-percent interest. These usually have a time limit — 6–12 months is normal — during which you can carry a balance without penalty, but as soon as the time limit expires, the interest rate kicks in.
    • Get a credit card with a grace period. A grace period is a time frame during which you can pay your credit card off without having to pay interest. Not all credit cards have a grace period, but the Credit Card Accountability Responsibility and Disclosure Act of 2009 (or Credit CARD Act) mandates that those that do should allow for at least 21 days. Grace periods usually only apply to purchases; they don’t apply to cash advances or balance transfers.

    Long term, however, the only guaranteed way to avoid paying interest is to pay off the balance on all of your credit cards every month.

    Lowering Interest Rates

    Lowering the interest rate on your credit card account may not be as difficult as you might expect.

    A 2014 survey by CreditCards.com found that 65% of the people who asked their credit card company for a lower interest rate got it. The problem is that only 23% of the 983 cardholders surveyed even bothered to ask!

    If asking strikes you as being a little too forward, there are other steps to get your interest rate reduced:
    • Be aggressive and on-time with payments. If your credit report shows that you make regular payments in a timely fashion and pay down as much debt as you can afford each month, card companies will be encouraged to reward you.
    • Check your credit score and negotiate. If you have a good credit score, most companies will want to do business with you. Compare your card with other credit cards. The credit card industry is fiercely competitive. If you receive offers from other companies via mail, compare it to the rates you pay, and then call your card company to ask them to beat the offer.
    • Loyalty helps. If you have been with a card company for five years or longer use that in the negotiation process. They don’t want to lose your business.
    • Ask a credit counselor for help. Non-profit counseling agencies can assist in getting your interest rate reduced and make it easier to pay off the card balance through a Debt Management Plan (DMP). You could see your interest rate drop under 10% and lower with a good DMP.

    When you comparison shop, be sure that you’re matching apples to apples. Annual fees, late fees, balance transfer fees and rewards should be identical or very close.

    And for the record, 86% of the people in the CreditCards.com survey who asked for a late payment fee waiver also received it.

    Variable, Fixed and Promotional Rates

    Officially, there are 3 types of interest rates for credit cards — variable, fixed and promotional. Realistically, however, there is only one. They are all variable to one degree or another.

    Some credit cards may start out with fixed and promotional rates, but inevitably those rates change, effectively becoming variable.

    Nonetheless, you may choose to start with either or fixed or promotional rate because it suits your goals. Here is a review of the pros and cons for all three:

    Variable Interest Rates

    Variable-rate plans have their interest charges based on benchmarks such as the prime interest rate, interest on U.S. Treasury Bills, the Federal Reserve Discount Rate or other indexes. The card company takes that rate and adds several percentage points (i.e. “a margin”) to come up with the rate it will charge you.  When rates are low — as they have been recently — this is the way to go.

    For example, the current prime rate is 3.50 percentage points. The card issuer adds a margin of 10-12 points for customers with good credit to come up with an APR of 12-15.5 percentage points. The margin is much higher (23-26 points) for those with bad credit, who will pay 26-29.5 percentage points.

    As the name implies, variable interest rates change at any time, increasing or decreasing based on the index on which they are built. In some cases, there is a cap on how high or low a variable interest rate can go, but card companies do not have to give you notice that the variable rate will be changing.

    And be aware that one late payment — whether for credit cards, mortgage or any other debt — could appear on your credit report and result in your APR going up.

    Fixed Interest Rates

    A fixed-rate card cannot change unless the card issuer gives the cardholder a 45-day notice. Cardholders either accept the change or decide not to use the card at the newer rate. Fixed rates are generally higher than variable rates, with the consumer paying a premium for the card’s relative stability.

    Fixed-rate card companies also can change rates if:
    • You are more than 60 days late with payment
    • You completed a debt management program
    • You had a promotional fixed rate that has ended

    The advantage of a fixed rate is that it’s stable. The card company must specify how long that rate will be fixed, and give you a 45-day notice when it will change the rate.

    Promotional Interest Rates

    Promotional interest rates usually are offered for a specified time and for particular uses. If you carry a balance on your credit cards, many cards will offer a zero-dollar balance transfer fee that can definitely help reduce the interest you pay.

    Some cards offer a cash bonus if you spend a specified amount in a specified time. Other promotional offers include zero-percent interest on purchases for as long as 15 months or 10% off an item purchased from the retailer offering you a card.

    These are all beneficial as long as you read the fine print under those claims. This is what tells you how long the promotion lasts and what the penalties are when that deadline passes.

    For example, cards that offer zero-percent interest for 12 months require the balance to be completely paid off at the end of 12 months — otherwise, interest rates kick in immediately. There also could be interest charges for payments that are missed or less than the minimum payment due during the 12-month period.

    There is another disadvantage of opening an account for a promotional offer: it could affect your credit score negatively because of the increased risk to lenders.

    Overall, analysts suggest consumers be wary of promotional offers. Read the conditions closely, and be sure to set reminders when deadlines approach.

    Interest Rates and Debt to Income Ratio

    Card issuers offer different interest rates to borrowers because of the differences in each financial profile. One metric used to measure a borrower’s ability to repay is the Debt to Income Ratio (or DTI). The DTI is calculated by adding up a card applicant’s outstanding obligations and then dividing by his or her income.

    The resulting percentage is used to estimate the potential default (or loss rate) to the lender for borrowers with similar DTIs. The card’s interest rate is a reflection of that risk factor. The greater the risk, the higher the interest rate.

    While individual borrowers may differ on their ability to repay credit, card issuers also rely on the concept that borrowers with similar credit scores will tend to exhibit similar payment behavior. For example, the lower a person’s credit score, the more likely that he or she may default on a loan, thus the interest rate would be higher.

    Credit Card Legislation

    The Truth in Lending Act (or TILA) was first passed in 1968 to regulate the way in which costs associated with borrowing, including credit card accounts, had to be calculated and disclosed. It was amended several times over the years, most recently by the Credit CARD Act of 2009.

    Among its many provisions, the Credit CARD Act:
    • Requires card issuers to increase the amount of notice consumers must receive before they issue any change in interest rates or loan terms
    • Prohibits card companies from retroactively increasing interest rates
    • Limits the way fees are assessed
    • Requires due dates to fall on the same day of each month
    • Enumerates certain rights granted to cardholders

    All federal legislation concerning credit cards is now under the supervision and enforcement of the Consumer Financial Protection Bureau (or CFPB), created in 2011, under the authority of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

    Current Credit Card Usage

    As of 2014, an estimated 175 million Americans have at least one credit card and use it often to make retail purchases and pay bills. About 18% of the cardholders carry 3-4 cards, 9% carry 5-6 cards and 7% carry seven or more cards.

    The Federal Reserve Board says the amount of revolving debt on those millions of cards was $929 billion as of November 2015 and the average APR on cards with a balance is 15.1%.  That means that credit card interest payments make up a significant portion of the national economy.

    Credit card issuers compete with one another to attract customers with an array of perks and bonuses. With reward plans, cash back programs and variable fee structures that abound, a savvy consumer should shop around. However, a card’s interest rate is still the most significant barometer of its ultimate value to its issuer and thus the highest potential expense for the user who doesn’t pay the balance off completely every month.

    Bill Fay

    Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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