In this post, we're going to talk about credit card interest rates and how they work. We will provide a few breakdowns as an example as well to give you a general idea of what you can expect if you're dealing with credit card debt.

What is Credit Card Interest?

Interest is when a credit card company charges you for the privilege of borrowing their money. The most common term that it is known by is Annual Percentage Rate, or APR. Most to all credit cards have variable APRs that will increase with a particular benchmark, such as a prime rate. If you have a prime rate of 4%, and your credit card charges you the prime rate plus 12%, your APR in total will be 16%.

*Important Note* - As of June 2023, the average APR of credit cards tracked was 23.74%

When it comes to credit card interest rates, you are only charged interest if you're not able to pay your bill in full each month. That's why it's beneficial to pay your credit cards to zero each month, if you're capable of doing so. When you do carry a balance over, the credit card company charges interest on the unpaid balance of the card, and that adds that charge to your overall balance. That is why credit card balances have the ability to grow on a rapid pace and for some individuals, they get out of hand.

What makes things even more difficult, some credit card companies are able to charge multiple interest rates. For example, some credit card companies may charge you on purchases that you make, but another charge (typically much higher) on cash advances.

How does Credit Card Interest Work?

If you carry a balance on any credit card that you have, that creditor will multiple it each day by a daily interest rate and add that to what you owe. The daily rate is your annual interest rate (the APR) divided by 365.

So for example, if your card has an APR of 16%, the daily rate would be 0.044%. If you had an outstanding balance of $500 on day 1, you would incur $0.22 in interest that day along, for a total of $500.22 starting on day 2.

The process continues until the end of the month. If you had a balance of $500 at the beginning of the month and added no other charges, you would end up with a balance of $506.60, including the interest that was charged.

So let's use that calculation and talk about minimum payments and point out exactly why it's so difficult to make progress on credit card debt when you have balances carrying over.

Principal: $500

Minimum Payment: $25

Interest: ($500 x 16%)/12 months = $6.67

Principal Repayment: $25 - $6.67 = $18.33

Remaining Balance: $481.67

Month 2: $481.67 + $6.60 (compounding interest from above) = $488.27

So with that breakdown, essentially what that means is if you have a $500 balance on a card and you do NOT use the card at all throughout the month to add more expenses, you've paid $25 on the card, but by the time you go to make month 2 payment, it will be a balance of $488.27, which means it really looks like you've only paid $11.73 towards the balance. So you paid $25, and essentially half of it goes towards interest, in retrospect.

That is a quick and easy breakdown to show why it is so difficult to make progress on credit card debt. And that was a simple example of of a $500 balance with a conservative interest rate of 16%. We all know that most to all people pay a lot higher on interest rates. As we pointed out with the important note above, the average APR as of June 2023 is 23.74%, which means on average, a lot more money goes towards interest, and a lot more adds up on the credit cards over the course of the following month. Let's use a bigger rate and balance as an example below with a $2,000 balance and a 20% interest rate.

Principal: $2,000

Payment: $60 (3% of the balance)

Interest: ($2,000 x 20%)/12 months = $33.33

Principal Repayment: $60 - $33.33 = $26.67

Remaining Balance: $1,973.33 ($2,000 - $26.67) *$33.33 went to interest*

Let's not even worry about adding the accruing interest throughout the month on this one. Let's just use these calculations as is and see these calculations are carried out every month until the card is paid off. REMEMBER, this also considers not using the card at all throughout the entire pay back time period.

If you stay on the current path of the second example above and only paying the minimum, you will spend a total of $4,241 over 15 years to pay off your $2,000 of debt that you owed. The interest alone will cost you $2,241.

Lastly, let's just use that example and say you used the card one time in the month to put gas in your car, and you used the card for $50 for a tank of gas. Let's take a look at the numbers with one single purchase for gas in your vehicle after the first month.

Principal: $2,000

Payment: $60 (3% of the balance)

Interest: ($2,000 x 20%)/12 months = $33.33

Principal Repayment: $60 - $33.33 = $26.67

Remaining Balance: $1,973.33 ($2,000 - $26.67) - *$33.33 went to interest*

Month Two: $50 charge for gas in your vehicle

$1,973.33 + $50.00 = $2,023.33

Month Two Balance = $2,023.33

You paid $60 in the first month, used the card once in the second month for $50 of gas, and your new balance is $23.33 higher than where the balance started at month one. Crazy right? That's the recurring cycle most Americans find themselves in. Your budget gets a little too far stretched out, you have to rely on the credit cards for expenses at the end of the month to cover small basic expenses, and the balances on your credit cards sky rocket. The credit card company has won.

Yes, credit cards are efficient and it's nice to have them, but you need to make sure you do not spend more than you make and live life trying to play catch up with credit card interest rates. The banks are the richest in the world. They know how to make significant profits. Don't become a hostage to your credit cards.

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