How does credit card interest work?

What is a credit card?

A credit card allows you to borrow money from a bank or financial institution to make purchases, up to a maximum credit limit. You’ll need to repay the money you borrow at a later date, plus any fees or charges associated with the card, as well as interest that may accrue on any money you owe.

There are a few different ways interest may be charged, depending on how you use your credit card. But if you use your card carefully, you may be able to avoid paying any interest.

How is credit card interest calculated?

The exact method by which your interest is calculated may vary depending on your provider, but major financial institution CommBank says that it calculates interest on credit purchases using the following formula:

1. Average the balances over the statement period
2. Multiply the average balance by the applicable daily interest rate (annual rate divided by 365)
3. Multiply the above amount by the number of days in the statement period

Other providers may use a similar formula for calculating your credit card interest.

What is an interest-free period on a credit card?

If you’re using your credit card to buy something—such as clothing, fuel for your car, dinner out, or concert tickets-you’ll usually have a period of interest free credit so long as you paid your last closing balance in full.

Amanda Cassar, director at Wealth Planning Partners, said it’s a good idea to try to make use of this interest-free period.

“Usually you’re not charged interest for purchases as long as the balance is paid in full at the due date every month,” she told Canstar.

“If you only pay part of the amount owing you will lose that interest-free period and be charged interest.”

The interest-free period is usually broken down into your statement period, typically from month to month, plus any extra interest free time allocated by your card provider. This interest-free period can vary from 0 up to 62 days according to credit cards on Canstar’s database, with the most popular being for up to 55 days.

The key wording here is “up to”. It’s not a fixed 55 days.

As Bank Australia points out, it’s a “common assumption” that the 55 days of no interest is from the time of each purchase.

“Actually, that’s not quite the case,” the bank says.

When you get your credit card statement, it will tell you how much you owe and the date payment is due. It will also detail any purchases you’ve made in that billing period, which will be everything since your previous statement. The earliest of which may be some 55 days from the due date, others will be more recent.

CommBank gives the example of someone who used his credit card to buy a $100 pair of shoes on day five of his 55 day interest-free period and a $1,000 television on day 25. Come due date, if he doesn’t pay the $1,100 owing in full he’ll start to be charged interest on any outstanding balance and those two purchases would have fewer than 55 days of interest-free credit.

Hence the phrase “up to” when describing any interest-free period.

If you lose that interest-free period, one way to regain it is to clear the full amount owing on your credit card.

Do all transactions have interest-free periods?

It’s important to know that not all transactions you make with your credit card will have interest free periods.  If you use your credit card to access cash (such as at an ATM)—known as a cash advance—then you can expect to pay a higher interest rate on that transaction, with no interest-free period. You may also be charged a fee.

You may have used your credit card for a balance transfer from another credit card, or to consolidate several credit card debts into one card. Interest may be charged on your transferred balance at a lower rate for a period of time, or may incur no interest, depending on the balance transfer promotional offer. Any new purchases you make on that card will usually attract a higher interest rate.

Is credit card interest expensive?

The amount of interest you pay on any money owing on your credit card depends on how you use your card. The average credit card interest for everyday purchases can be between 15% to 20% a year – the annual percentage rate (APR)—but rates can be higher or lower depending on the card you have.

When you make a repayment on any outstanding amount, the money may go first towards paying off the debt that attracts the highest interest rate.

This can sometimes be an issue if you’ve used your credit card for a balance transfer, as you’ll want to clear that amount owed before any promotional period ends, otherwise you may then be charged interest at a higher rate on that amount.

Given the many different rates of interest that may be charged to your credit card account, that can make it tricky to work out in advance what you might expect to pay. But whatever interest you are charged is usually calculated each month and added to any amount owing.

Dr Campbell Heggen, a Senior Lecturer in Financial Planning at Deakin University, said if you don’t clear the amount owed in full, the interest will compound. That means you’ll effectively be charged interest on interest.

“This has the effect of further increasing the amount of money you owe, making it harder and more expensive to repay your debt,” he told Canstar.

Dr Heggen said one option you could consider is to use any money you may have in a savings account to help pay off that credit card debt.

“There is usually a large gap between the relatively low rate of interest we earn on our savings versus the much higher rate of interest we are paying on credit card debt,” he said.

“Often, a more effective strategy would be to first focus on clearing all forms of expensive personal debt, such as credit cards, and then aim to increase your wealth via saving and investing.”

Should you make more than the minimum repayment on your credit card?

Your credit card statement will detail a minimum payment required to avoid paying any penalties, but note this will usually be a relatively small amount.

The Federal Government’s Moneysmart website says this minimum payment is typically 2% or 2.5% of the amount owing, or a set dollar amount (e.g. $20), whichever is greater. Check with your card provider to see how it calculates the minimum payment.

Your credit card statement should say how long it will take to repay the amount owing if you only repay the minimum amount, and how much total interest you’d end up paying over this time period.

For example, using the Moneysmart’s credit card calculator, if you owe $1,000 on a credit card that charges 15% interest and repay only the minimum required each month, it would take you six years and seven months to clear the debt and you’d pay $579 in interest—more than half your original debt. This doesn’t even take into account any extra fees you may be charged.

This can be a good incentive to either pay off the credit card during the interest-free period, or pay as much of that debt owing as you can to avoid paying too much in interest.

If you’re looking to make a purchase you’d prefer to pay off over a long period of time then you could also consider taking out a personal loan instead. Personal loan interest rates are typically lower than those for credit cards.