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How Does Credit Card Interest Work?

Sure, that credit card may seem handy when you’re Christmas shopping for your entire family or snagging those Taylor Swift tickets.

But it only takes one emergency purchase (or one too many treat-yourself moments) for that piece of plastic to put you in the red. And by the time you realize what’s happening, interest has already started to pile up faster than the toppings at Chipotle.

So, how does credit card interest work? Sit tight—we’re going over the ins and outs of credit card interest and what you can do to avoid paying the toll.

What Is Credit Card Interest?

Credit card interest is a fee the credit card company charges you for borrowing money. Because here’s the deal: You’re not spending your own money when you swipe your card, even if you think you are. Any time you use a credit card to buy anything from eyeglasses to an iPad, you’re actually using the credit card company’s money to purchase it.

But they’re not spotting you the cash out of the goodness of their hearts. Nope, you’re expected to pay that money back on time and in full. And if you don’t? Well, that’s when you get charged interest.

How Does Credit Card Interest Work?

Credit card interest can be summed up in three letters: APR (aka the annual percentage rate). And even though it’s called the annual percentage rate, APR is usually charged monthly or even daily. So, if you don’t pay off your credit card balance by the end of your billing cycle, you’ll be charged a percentage of your unpaid balance—on top of what you already owe.

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Most credit cards also have a minimum payment. But be careful not to confuse that for paying your balance in full. While paying the minimum payment may technically keep you in “good standing” with the credit card company, you’ll still get charged interest on whatever you didn’t pay.

Maybe you’re thinking, Okay, so I’ll just pay off my credit card balance each month to avoid paying interest. That’s a nice thought, but credit card companies wouldn’t have giant skyscrapers and celebrity spokespeople if everyone actually did that.

In fact, only about half (52%) of Americans who had a credit card actually paid off their balance each month in 2021.1 Those definitely aren’t the best odds when your hard-earned money is on the line.

And don’t even get us started on all the random credit card fees you can still get charged (including annual fees just for the “privilege” of having a credit card). Um, no thank you!

What’s the Average Credit Card Interest Rate?

As of 2022 Q4, the average interest rate on credit card accounts is 20.4%, which is literally the highest it’s ever been!2 And with federal interest rates on the rise, that number will probably get worse.

Of course, different lenders handle credit card interest rates different ways. And your interest rate may be higher or lower depending on the kind of credit card you have. But credit card APRs can be even higher than 20%.3

That can add up to . . . well, a lot of money. In fact, the average credit card debt is $5,474.4 In other words, credit card interest is a risk you can’t afford to take.

How Is Credit Card Interest Calculated?

So, where exactly does your interest payment come from? It’s time to dust off that old algebra textbook, sharpen those pencils, and get out your graphing calculator. Just kidding! You don’t have to be an accountant to figure out how much you’re paying in interest, but there is some math involved.

1. Identify your APR.

If you don’t already know your credit card’s APR, it’s time to find out. Your rate will depend on what kind of card you have, so go ahead and hit up the credit card company’s website or call them to find out what yours is. But keep in mind that you may have more than one APR if you’ve got multiple cards.

For this example, let’s use a credit card APR of 15%. In decimal form, that’s 0.15. Pretty easy so far.

2. Convert your APR to a daily interest rate.

Next, divide the number you just got by 365—the number of days in a year (unless it’s a leap year, but we’re getting off track). Why? Well, even though you might get a monthly bill, most credit card companies calculate the interest on a daily basis. So, 0.15 divided by 365 is 0.00041096. That’s the daily interest rate, but it’s not quite the number we’re looking for.

3. Determine your average daily balance.

Chances are, you charge multiple purchases to your credit card each month. But no matter what your final total for the month is, the credit card company is more interested in the average daily balance you carried throughout the month.

It takes weeding through your recent card transactions and doing some extra math to figure out your average daily balance. (If you’re wondering what your current account balance is, you can find it on your most recent credit card statement.) But for the sake of simplicity, let's say the only thing you bought this month on credit was a new living room set for $2,100.

4. Calculate how much you’re paying daily.

Take the daily interest rate you figured out in step two and multiply that number by your average daily balance. That will give you the amount of interest—in dollars—that’s added to your account every single day.

For this example, $2,100 multiplied by 0.00041096 equals about 86 cents that you’ll have to pay in daily interest if you miss your payment deadline. But wait—there’s one more step!

5. Don’t forget daily compound interest.

So, 86 cents a day for 30 days (a typical billing cycle) comes out to $25.80 in interest. That may not sound like a lot now, but it can add up quick, especially if you’ve got other purchases on your card.

But don’t be surprised if that number on your credit card statement is higher. Most credit card companies use compound interest to determine daily charges—which is basically interest on the interest you’ve already racked up. And listen, we like compound interest when it helps grow your investments. But it straight-up sucks when it’s being used against you.

Trying to figure out daily compound interest on your own can be pretty tricky (lucky for credit card companies). But we’ll save you the headache for this example. Just know there’s a lot happening behind-the-scenes to make you pay more.

Oh, and don’t forget about credit card fees and late payments. Plus, if you stop paying the minimum monthly payment altogether, your debt will eventually become delinquent and go into collections (cue Jaws theme song).

How Is APR Determined?

So, now we know how interest is calculated, but who decides your annual percentage rate? It may seem like credit card companies just spin a giant APR wheel, but there actually is some logic behind the number.

If credit card companies are going to lend you money, they want to make sure you’ll pay it back. And if there’s a higher chance you won’t pay off your credit card bill each month, then they’ll probably give you a credit card with a higher APR.

So, your interest rate usually depends on your credit score and your income—things that show you’re more likely to pay off your balance regularly. In the credit card biz, they call this someone’s “creditworthiness.” But wait a minute. The only way to prove you’re “worthy” enough to borrow money is to borrow money? Whose idea was that? Oh yeah, the credit card companies’.

In addition to your own credit history, there’s also certain APRs for different kinds of transactions, rewards and credit accounts. Here’s a quick rundown of each APR type:

Variable APR

Variable APR means your interest rate can change. The rate is usually based on the prime rate, which is an average of what banks across the country are charging in interest. When the prime rate changes, so does your individual interest rate on your credit card. That means you could end up with a sky-high interest rate real fast. Not cool.

Fixed APR

Fixed APRs tend to stay the same. But there are still some reasons why a credit card company could raise your rate—like if you’re more than 60 days late on a payment. Don’t let fixed rates fool you, though. They can still put you in debt just as fast.

Purchase APR

This is the interest you get charged on credit card purchases when you don’t pay off your entire balance by the due date each month. It’s the most basic type of APR.

Cash Advance APR

A lot of credit cards will hit you with a separate cash advance APR when you borrow against your credit limit. It’s the same as if you used a debit card to take money out of an ATM before it was in your account.

With cash advance APRs, there’s no grace period (the time between the end of your billing cycle and when your payment is due), so you will pay interest no matter how fast you pay it back. And cash advances typically have a higher interest rate than normal purchases. You could also get charged additional fees every time you do a cash advance.

Balance Transfer APR

A lot of credit card companies also have a separate APR for any balances you move from one card to another (aka a balance transfer). They may offer a low rate at first, but these usually don’t last long and will spike back up once the intro period is over.

But moving your balance from one card to another to avoid paying interest doesn’t solve the problem—it only delays it. Plus, there’s usually an additional balance transfer fee you’ve got to pay.

Penalty APR

You get hit with a penalty APR when you spend more than your credit limit or make a late payment. And again, you’ll probably also get charged late fees on top of that. Ouch.

Introductory APR

Credit card companies will offer a low introductory APR as a perk for opening a specific kind of credit card account. But these low introductory APRs (sometimes called a promotional APR) usually jump up after a certain period of time. And by then, you’re already hooked. Ah, the old bait and switch.

Other Types of APR

Of course, there are also store credit cards, cash back cards, airline miles cards and cards that offer points for hotels—basically, if there’s a perk, they’ve made a credit card for it. But credit cards with rewards usually have higher interest rates or annual feesYou didn’t think those free perks were actually free, did you?

Let’s say you have a credit card that offers 3% cash back. You would have to spend $1,000 just to get $30 back. Really? That’s not winning. That’s being part of a system that makes money off millions of people. Credit card rewards are just a way to get people to spend more each month, which increases the chance they’ll carry a balance and (you guessed it!) be charged interest.

Even if you have a lower APR, don’t get too comfortable. Credit card companies still have the power to raise your interest rates on new cards, and in some cases, they can even raise the rates on current balances—so no APR is guaranteed.

How to Avoid Credit Card Interest

Okay, now that you know how credit card interest works, let’s talk about how to avoid it.

Of course, one way to not pay interest is to pay your credit card balance in full and on time every single month. But like we said before, that only works until your pipes burst during a winter storm or your transmission goes out. Trust us, credit and emergencies do not mix.

The best way to avoid paying credit card interest is to pay off your credit card and then cut it up! Better yet—don’t have a credit card to begin with.

But what if you already used your credit card to buy that new couch, home entertainment system or vacation to Cabo? If you’ve got credit card debt or a big balance threatening to push you into interest territory, here are some steps you can take to get out of the danger zone.

Get on a Budget

When you use a credit card, it can be hard to know where all your money is going and if you have enough for the rest of the month. But when you make a budget, you can know exactly how much you have left to spend. You never have to worry about going over your credit limit or not being able to pay your credit card bill—because you already made a plan for every single dollar of your paycheck.

If you want to be in control of your money, you need a budget. Seriously, it’s a total game changer. And it doesn’t have to be complicated! You can go ahead and create a budget for free right now with EveryDollar.  

Work the Debt Snowball

If you want to avoid paying credit card interest (or more interest than you’ve already been stuck with), you’ve got to get serious about paying your balance off. And the debt snowball method is the fastest way to tackle your credit card payments because it boosts your progress and changes your behavior.

Here’s how it works:

Step 1: List your debts smallest to largest, regardless of interest rate (we know we’ve been talking about the importance of interest this whole time, but trust us when we say it doesn’t matter in this step). Pay minimum payments on everything but the smallest balance.

Step 2: Attack the smallest debt with everything you’ve got. Once that debt is gone, take that payment (and any extra money you can squeeze out of your budget) and apply it to the second-smallest debt while continuing to make minimum payments on the rest.

Step 3: Once that debt is gone, take its payment and apply it to the next-smallest debt. The more you pay off, the more your freed-up money grows and gets thrown onto the next debt—like a snowball rolling downhill.

The faster you work on your debt snowball, the sooner those credit card payments—and that interest—will stop cramping your monthly budget.

Use Other Payment Methods

Debit cards, PayPal, Apple Pay, Venmo—there are so many payment options that are better than a credit card. But there’s nothing quite as satisfying as paying for something with cold, hard cash. When you swear off credit cards, you can make your purchase without having to worry about it haunting you in the form of interest later.

Even if you think you can stay on top of your credit card payments, why risk it? Relying on credit cards and hoping you won’t have to pay interest is like dancing through a bed of snakes to get a McDonald’s Happy Meal toy—you’re probably going to get bit (and it’s not going to be worth it).

If you're ready to steer clear of credit card interest and say goodbye to credit card debt forever, it’s time to ditch the toxic money habits that are holding you back. 

Financial Peace University (FPU) will show you how to budget, pay off debt, save for emergencies, and build wealth for your future. In this course, you'll learn the proven plan that’s helped almost 10 million people just like you not only live without credit—but thrive without credit!

It's time to quit the credit card game and build the life you want with your money. Start FPU today.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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