Credit cards can be a convenient financial tool, but they can also lead to crippling debt if mismanaged. In this post, we’ll break down how credit cards make money, how interest payments are calculated, common misunderstandings about credit card payments, and some key pitfalls to avoid.
Before diving into interest calculations, let’s talk about how credit card companies make money. It's not just from the interest you pay. Credit card issuers make many in several different ways, including:
Now that you understand the various ways credit card companies make money, let's zoom in on how credit card interest is calculated.
Most people understand that carrying a balance on a credit card means paying interest, but many don’t fully grasp how that interest is calculated. Credit card interest is usually charged based on a daily interest rate derived from your card's annual percentage rate (APR). Here’s a step-by-step breakdown of how it's calculated:
The APR, or Annual Percentage Rate, is the yearly interest rate charged on outstanding credit card balances. For example, if your credit card has an APR of 18%, this is the interest rate applied over the year.
Since interest is calculated daily, you’ll need to find your daily periodic rate. To do this, divide your APR by 365 (the number of days in a year). For instance, an APR of 18% gives you a daily rate of 0.0493% (18 ÷ 365 = 0.0493).
Each day, your credit card issuer calculates the interest on your balance. If you owe $1,000, for example, the interest for one day would be $0.493 ($1,000 x 0.0493%).
Assuming your billing cycle is 30 days, you would then multiple the daily interest of $0.493 by 30 for a total of $14.79. Thus, the new balance owed on a balance of $1,000 would be $1000 + $14.79 = $1,014.79.
Understanding how interest is calculated can help you avoid costly mistakes, but many people still have misunderstandings about credit card payments. Let’s clarify some of the most common ones:
Managing credit card interest effectively comes down to smart usage and avoiding common financial missteps.
Here are some key financial decisions to avoid:
While it’s tempting to only make the minimum payment, doing so means you’ll accrue interest on the remaining balance, which can quickly snowball. Try to pay off your balance in full each month to avoid interest charges.
Not only does making late payments lead to late fees and penalties, but it can also negatively impact your credit score. Set up automatic payments or reminders to ensure your payments are made on time.
Credit cards make it easy to buy things you might not be able to afford with cash. Avoid using credit for impulse purchases or items that aren’t essential, as this can lead to debt that accrues unnecessary interest.
Your APR determines how much interest you’ll pay, so it’s important to be aware of it. Cards with rewards programs often come with higher APRs, so make sure the benefits outweigh the potential costs if you carry a balance.
Understanding how credit card interest is calculated is a critical step in managing your financial health. Credit cards offer a lot of flexibility and benefits when used correctly, but they can also lead to debt if you don’t understand how interest accumulates. By being mindful of your spending, paying off your balance in full each month, and avoiding common pitfalls, you can use credit cards to your advantage while maintaining financial wellness.
Disclosure: Kasheesh is a financial technology company, not a bank. Banking services provided by Bangor Savings Bank, Member FDIC. Kasheesh's Mastercard® Pre-paid and debit cards are issued by Bangor Savings Bank, Member FDIC, pursuant to license by Mastercard International Incorporated. Mastercard is a registered trademark, and the circle design is a trademark of Mastercard International Incorporated. Spend anywhere Mastercard is accepted.
The content on this blog is for general information purposes only, and is not intended to be personal financial advice. It does not take your individual circumstances and financial situation into account, and any reliance you place on the information is at your own risk.
Basic information to verify your identity. Creating an account is quick and easy! No sign up fee, no credit check.