How interest rates are applied on credit cards

How interest rates are applied on credit cards

In the modern economics and financial system, a loanee is subjected to pay an interest rate (applied on the principal amount) along with the principal amount that was borrowed. This interest rate is also called the cost of borrowing rate which is applied on loans and credit cards balances. Interest rates that are applied on borrowing of money are called the annual percentage rate or APR.

Understanding the interest rate can be a bit complex job however, for a person using credit cards and loans for borrowing or lending money, it is worth investing the time.

In the following article, an overall idea and overview of how interest rates apply on your credit cards is provided.

How an interest rate is charged

Most of the credit cards in European nations have a ‘grace period’. If you pay all the balance during the grace period, no interest rate is applied on your balance and you only pay the principal amount. Any credit that is left unpaid after this grace period will be subjected to the stated interest rate or finance charge.

Finance charge

Finance charge is the interest fee that is applied on your balance of credit cards. There are several ways to calculate the finance charges. Following are the six methods of calculating the finance charges on credit cards:

Adjusted balance method

In this the balance at the start of the billing cycle is used excluding any payments that have been cleared already. This is one of the efficient method of calculating the finance charges.

Average Daily Balance method

This is one of the most approach used to calculate the finance charges. In this, the average of balance during the entire billing cycle is used. For average, every single day’s balance is summed up and divided by the number of days.

Daily Balance method

In this method every single day’s balance is used for the billing cycle. The every single day’s balance is then multiplied with the daily rate and added up.

Double Billing Cycle method

This method uses the daily balance for the current as well as the previous billing cycle. This is one of the most expensive way of charging the finance costs. Fortunately for the credit card users, this method is considered unlawful.

Ending Balance method

In this method, the beginning balance minus the payments throughout the billing cycle plus the overall charges during the period. Number of days in billing cycle do not affect the finance charge amount.

Previous Balance method

This method uses the ending balance from the previous billing cycle. No other payments or charges are included in this. There is also no effect of number of days in billing cycle on the finance charge amount.

Fixed and Variable Interest Rates

The two basic types of interest rates that apply on credit cards are the fixed and variable interest rates. Fixed interest rate remains stable at the same rate, the rates can only be increased by the credit card service provided after a prior notice.

Variable interest rates are based on other interest rates e.g. the prime rate. So, the credit card service providers don’t have to give an advance notice to their customers before changing the interest rates.

Different types of APR

European credit card service providers have different types of annual percentage rates for different services. Before getting a credit for yourself, you should be aware of these terms and the interest rates that are applied on particular services. For example, credit card purchases, balance transfers and cash advances, all have different APRs applied on them. There is also a penalty APR that is added when you default on your credit card terms e.g. late payments.

Periodic Interest Rates

Mostly, the interest rates are charged on monthly or other periodic bases. Every card comes with a periodic rate which is just an interpretation of the interest rate per year and is easy to calculate.

For example, if the interest rate applied is 18% per year, simply by dividing the 18% interest rate by 12 (months), you can find the per month interest rate (in this case, 18%/12 = 1.5%). If you want to know the per day interest rate, simply divide the 18% with number of day (365) and you get the per day interest rate that is charged (in this case, 18%/365 = approx. 0.05 %)

Increase of interest rates on your balance

If the bank is looking to increase the interest rate that is applied on your balance, it must do that after a 45 day advance notice. You, as a customer, have the option to avoid this increase. You might be barred from availing the credit card services but you will not be subjected to increased finance charge on your existing balance.

How can you avoid the Finance Charges?

In most of the European credit card services, you can avoid finance charges by paying the full balance in the grace period. However, with certain balance such as the cash advances and balance transfer it is almost impossible for a customer to avoid the interest payments because they don’t have grace period on them.