How does credit card interest work?

Despite their prevalence, credit card interest remains poorly understood. This article demystifies it.

There are a few important things to know about the factors determining your interest rate. Specifically:

• If a card's rate is fixed, the credit card company will set a base APR and add additional APR percentages based on your credit history.
• If the card's rate is variable, the credit card company will set the card's base APR a few points above the index rate, and add additional APR percentages based on your credit history.

Let's delve deeper into how credit card interest works.

What is credit card interest?

Credit card interest is the fee charged for unpaid balances after the due date.

How does interest work on a credit card? The process goes like this:

• You pay a credit card bill using your small business credit card. You now have an outstanding balance on your card.
• Your credit card issuer specifies a repayment date. If you repay your outstanding balance before this date, you will not incur interest charges.
• If you fail to pay before the due date, your card provider will add interest charges to your outstanding balance.

Paying balances on time avoids interest, improves your business credit score, and unlocks better rates and rewards.

How does credit card interest work?

Calculate credit card interest by dividing the APR by the number of days in a year (usually 365), and multiplying that number by your outstanding balance. You will start accruing interest charges daily if you fail to repay your outstanding balance.

How a credit card’s interest rate is set

Credit card interest rates are either fixed or variable. Fixed rates, as the name suggests, do not change. Variable APRs change based on the value of an underlying index, usually the interest rate set by the Federal Reserve or a country's central bank. This rate is usually called the prime rate.

Here's how credit card companies calculate your credit card's interest rate:

• The credit card issuer reviews your application, noting your credit score and current debt burden (outstanding business loans, vehicles, etc.)
• The issuer "pulls" your credit report and verifies your payment history, the number of credit accounts, and credit score.
• If the issuer decides to offer you a card, they either set a base APR and add additional APR percentages based on your credit history or fix the card's base APR a few points above the index rate.

Your credit card's interest rate depends on the prevailing interest rates in the economy and your credit history.

Credit card interest formula

Here are the steps to calculate credit card interest you’ll pay over several days:

1. Note your APR from your monthly statement balance. This is the annual interest rate.
2. Calculate your daily interest rate. Divide the previous number by 365.
3. Multiply your outstanding balance by the daily rate.
4. Multiply the previous number by the number of days.

For instance, how do you calculate 24.99 APR? With a 24.99% APR and a $1,000 balance, the daily interest is approximately $0.69, or (24.99%/365) x $1,000. Over 30 days, the accrued interest would be $20.70, or $0.69 x 30.

How is APR calculated on a credit card?

Credit card APR is calculated by dividing the annual interest rate by 365 to get the daily rate, then multiplying that by your outstanding balance. This daily interest accrues until the balance is paid, or the next billing cycle begins.

Why are interest charges so high?

Credit card interest rates are high due to the unsecured nature of the debt and the associated risk for lenders. Because there's no collateral backing the loan, lenders compensate for potential losses by charging higher interest, particularly to borrowers with lower credit scores.

This is how credit card companies generate revenue and manage risk.

Credit card interest and small businesses

Due to high interest rates, small business owners should exercise caution when using credit cards. If you fail to pay your balances back on time, you'll be stuck with interest rates far greater than other funding options. For instance, current SBA loan rates average 9.75% (see our SBA loan calculator tool to find the best payment terms for your business).

Credit card issuers refer to interest as the Annual Percentage Rate or APR. Many credit card providers offer introductory APRs of 0% for 6 to 12 months.

That said, there are different types of interest that small businesses owners will come across as cardholders. Here are the different kinds of credit card APRs:

• Purchase APR: Charged on unpaid purchase balances.
• Balance transfer APR: Charged for transferring balances between cards.
• Cash advance APR: Cash advance APRs are charged for cash withdrawals not repaid by the due date.
• Penalty APR: Applied when balances are carried too long, added to the purchase APR.

How to prevent or reduce credit card interest charges

In order to leverage the benefits credit cards offer, you’ll want to make sure to avoid paying compounding interest as much as possible. Thankfully there are a few ways to do just that.

Pay fully during the grace period

This is the most simple way to avoid interest entirely: pay your principal full balance every month. Every corporate card issuer will give you time to repay your balance before interest kicks in. To avoid interest, always pay your full balance within the grace period (typically 20-30 days). Avoid only making the minimum payment, as this allows interest to accrue on the remaining balance.

One way of monitoring your credit card spending is to use a prepaid credit card for business.

Understand interest terms

Credit card interest terms can be confusing. Make sure you discuss all terms with your credit card issuer. For instance, figure out how your interest rate will change with a variable rate card. If your issuer offers a 0% intro APR promotional period, note the purchase APR after that time.

Some credit card issuers offer zero balance transfer APRs but ask you to repay the balance within a fixed billing cycle. Fail to clear the balance, and you'll pay extremely high APRs.

As a rule of thumb, it’s a good idea to track business expenses on your credit cards and avoid carrying balances. Transfer cash balances only if you understand repayment terms and all the charges involved in the process.

Transfer balances to other cards

Balance transfers to low interest credit cards are a great way to reduce interest charges. For instance, let's say you are carrying $10,000 outstanding on a 20% APR credit card. Your annual interest is (20% of 10,000) $2,000.

If you can transfer this balance to a 15% APR card (annual interest $1,500,) you'll save $500 annually. If the new card has a 0% APR offer that lasts for 6 months, you will save even more ($1,250).

Carefully review the new card's terms, including the post-promotional APR and any transfer fees, to ensure the transfer remains cost-effective.

Draw a loan to pay off credit card balances

If balances are too high, consider personal or business loans, or crowdfunded debt. Evaluate cash flow with business budgeting software before proceeding.

Pay attention to cashback and partner offers

Credit cards can offer you huge rewards when used correctly. For example, many credit cards offer businesses travel and cashback advantages that put money back in your pocket. In some cases, you can use cashback from one card to reduce your interest expenses on another.

However, you must understand credit card interest basics properly before using card features this way. Remember that as long as you repay credit card interest during the grace period, you won't incur interest and can participate in all rewards.

Ramp: An interest-free corporate card alternative

Whether it's simplifying expense management for your employees or discovering savings, Ramp can help you automate and monitor spending.

• Unlimited virtual and physical cards: Ramp's virtual cards offer all the benefits of a credit card without the interest. Our unlimited virtual credit cards for business are accepted by merchants everywhere.
• Easy expense controls: Card spending can get out of hand if you neglect it. Ramp helps you take control of expenses by setting digital policies, so you can establish a healthy financial culture in your company.
• Seamless accounting: Ramp's automated accounting integrations pulls data related to cards, bills, audit trails, and accounting, giving you a quick picture of financial performance. You can import financial data to popular accounting platforms for small businesses such as Xero, Sage Intacct, Netsuite, and Quickbooks with a few clicks.
• Discover savings: Ramp simplifies expense management and unearths savings thanks to pricing intelligence and expense reports. Ramp also alerts you to unused partner spending rewards, helping you squeeze more out of your subscriptions.

Learn how Ramp streamlines expense management and saves you money.