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How is credit card interest applied

how is credit card interest applied

By Erica Sandberg

Dear Opening Credits,

Hi, I'm new to opening credit. In regards to credit cards, is interest applied to a person's credit limit or is this a separate charge? Could this vary between credit card companies? -- Gabriel

Dear Gabriel,

Welcome to the wonderful world of credit cards! I'm glad to be your guide, because I get to be here for the start of your tour. Now I can make sure you have the information you need so you can avoid straying into dangerous territory.

This is how it works -- from the beginning credit line to the final cost.

  • Credit limit. When you get a credit card, the issuer (which might be a bank, credit union or credit card company) sets a maximum amount you can borrow. That's your credit line -- or limit. Some limits are in the low hundreds while others are practically infinite. The former is for newbies or people who have credit reports filled with late payments and high debt already. The latter is reserved for the most creditworthy customers -- people with active, excellent credit histories as well as incomes that can support exceptionally large payments.
  • Interest. The credit issuer also sets the account's annual percentage rate (APR), which is the interest rate the issuer calculates on unpaid balances. APRs tend to be higher for people with no or poor ratings, and lower for people with good credit ratings. Rates do vary from one creditor to the next, which is why it's important to shop around for the best card you can qualify for before deciding on one.
  • Charging. Every time you use the card to pay for something, the issuer is lending you the funds. That means, of course, that they'll want the money back. So in about four weeks, you'll receive a bill listing your charges for the month, the total balance, the minimum expected payment and the due date.
  • When and how interest is applied. When you get the bill, you have a choice. Pay in full or pay partially. But if you do pay less than the full amount, the remainder of the balance

    will be added to next months' bill and the issuer will add interest to it. Interest is charged on unpaid balances that are rolled over from month to month.

However, interest is never assessed on unused credit lines. That would be madness. Imagine it as a conversation you'd have with a friend regarding a loan.

Friend: "Hey Gabriel, I'm happy to lend you some money in case you ever need it."

You: "Wow, thanks!"

Friend: "No problem. And now that I've offered, I'll start to charge interest on what you might borrow."

You: "Um, I'm going to pass on that."

See? It wouldn't make any sense.

What is sensible, though, is to only charge the amount you'll repay quickly, because the cost to roll balances over can be extreme.

For example, let's say you get a credit card with a $2,000 limit and a 21 percent interest rate. You charge $1,200. If you send that amount by the due date, the loan is free. But if you settle into just sending the minimum required payment, it will take you more than 10 years and cost about $1,500 in interest to be in the clear. And that's if you stopped charging with the card entirely.

Of course, one of the advantages of credit cards is that you do have the option to pay over time, and it's not the end of the world if you break up the large debt into a few pieces. Yes, interest will be tacked on until the balance is zero, but it's the price of convenience. The same debt on the example card will only cost about $40 in interest if you paid it off in three months. A reasonable premium? That's up to you. Just know that the power to pay nothing, a little, or a lot in interest is in your hands.

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Sally Herigstad,

"To Her Credit"

Category: Credit

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