Credit card companies make money off the consumer in two ways; one is the fees they charge - whether that's an annual fee, late payment fee, or over-limit fee among others; the second is the interest they charge.
RBA data says the average credit card interest rate is in excess of 17.00% p.a. - much higher than what you might associate with a home loan or personal loan.
When you're in the process of comparing credit cards, you're often told to consider the interest rate, but what exactly is interest? And how do lenders calculate how much interest you pay?
Here's how credit card interest works and how you can pay less of it.
What is credit card interest?
A credit card allows you to access a line of credit up to an agreed amount with your lender, while interest is the amount you owe your lender on top of the money borrowed. Interest is typically expressed as an annual percentage rate or APR.
With a credit card, you pay interest on each purchase not repaid within your lender's 'interest free' period. In the case that you don't pay your bill in full each period, the credit card company charges interest on your unpaid balance and adds that charge to your balance.
A typical interest-free period is 55 days, however your credit card might have a shorter or longer period. Note, this is not reset each time you make a purchase; for example if you make a purchase on day 54, you will have to repay the balance in full the next day to avoid accruing interest.
How is interest calculated on a credit card?
When working out how interest is calculated, there are three factors to consider.
The annual percentage rate (APR): the advertised interest rate on your credit card
The daily rate: your APR divided by 365 days
The average daily balance: your account balance for the month, multiplied by the number of days in that month
Credit Card Interest Example
To explain this a little better for you, here's an example.
John Smith spends $2,000 in the month of March which has 31 days. His credit card interest rate is 16% (APR).
Take 0.16 and divide that by 365 days gives you 0.000438.
Then take 0.000438 x $2,000 x 31 days = $27.15 (John's monthly interest repayment).
Each month that any interest is charged will be added to your total outstanding balance. So, if you're not paying the interest off each month, it will cost more and therefore take you longer to pay off your debt.
Moral of the story? Pay your bill on time to avoid extra costs.
How often do you get charged interest?
Most lenders will charge interest monthly and you'll see this charge on your statement. If you're unable to pay the balance in full by the due date each month, you will be charged interest.
Nowadays, credit cards have interest-free days where there will be a set number of days you won't be charged any interest - so long as you pay off your entire monthly balance by the due date.
The typical number of interest-free days offered by credit card companies is between 44-55.
It's important to note that the interest-free period refers to the maximum number of interest-free days that are available on a purchase you made with the credit card. In order to receive the full 55 days' interest-free, a purchase must be made on the first day of the statement period.
For example, if you had a 55-day interest-free credit card and wanted to buy a fridge on day 20 of the statement period, you would only get 35 days' interest-free to pay off the fridge before you're charged interest.
Be mindful that there are credit cards out there that offer 0 interest-free days - they tend to lure customers in with low interest rates. 'Charge' cards also tend to have no hard credit limits but instead start charging interest after any purchases.
How to reduce paying interest on a credit card
There are few ways to minimise or avoid paying interest on your purchases, as interest is the cost of borrowing the money.
1. Stick to the interest-free period
The only way to avoid paying any interest is to pay off your purchases during the 'interest-free' period. You'll still have to pay any account fees for maintaining the card, however.
2. Pay off more than the minimum repayment
To reduce the amount of interest paid, consider paying off more than the minimum repayment by the due date. This will also help reduce the amount of money owed on the card and, in turn, will help you pay off the debt sooner. If you stick to the minimum repayment, a simple $100 purchase could balloon out in total cost and take a long time to pay off.
3. Stick to a repayment schedule and spend within your means
To remember your due dates, consider setting calendar reminders each month or, if your provider allows it, set up a direct debit to avoid the hassle of remembering.
Credit cards can be useful tools for people looking to take advantage of the rewards programs. They can also help you make the most of your budget, without missing out on anything in life. However, the interest you pay for not repaying off your bill can be steep.
To find a competitive interest rate, start comparing credit cards now.