You don't have to pay a lot to use a credit card. In fact, you can fork over extremely little to your credit card company if you choose a card with no annual fee, incur no fees such as those for late or insufficient payments, and pay your bills in full each month.
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However, if you can't swing that, here's the scoop on credit card rates and charges.
How interest rates work
The rates credit card companies quote can be misleading. If you're presented with an APR, know that that's the nominal rate you're charged, but that it's typically applied in increments daily, and by year end, thanks to the effects of compounding, it's usually higher.
For example, an APR of 15% translates to an annual percentage yield, or APY, of more than 16% when it's compounded daily. Ideally, when evaluating interest rates, look for the APY, as it can convey a clearer sense of what you'll earn -- or pay.
Credit cards can offer fixed interest rates or variable rates. In this environment of ultra-low interest rates, there are few fixed-rate cards (and even fixed rates will change now and then). Ones with variable rates often base their rates on a key benchmark rate, such as the prime rate, adding a few points to it and adjusting it over time as the underlying rate fluctuates.
Interest Rates in Action
A credit card's interest rate is very important because it's the thing that has the largest impact on what you pay if you do not pay off your balances quickly. Two examples:
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- Imagine owing $10,000 on a credit card with a 15% annual percentage rate (APR). If you pay $300 toward your debt monthly, it will take you about 44 months to pay it all off, during which you'll have paid $3,000 in interest payments.
- Interest rates topping 20% are not unheard of. If you carried that same $10,000 balance on a credit card charging 20% in interest, and you still paid $300 per month, then it would take you 50 months -- over four years -- to pay it off, and you'd end up paying $4,700 in interest. That's nearly half the amount you charged on the card!
How Your Charges Are Calculated
When comparing credit card interest rates, you should also consider what balance the interest rate is applied to in order to arrive at the interest charges. There are a handful of different ways a credit card plan can go about it, and the fine print accompanying your card will tell you which one is being used. Here are the main approaches:
- Average daily balance: This is the most common approach, where the card company takes the total of cash advances in the billing period (and often new purchases made during the period, too), adds any outstanding balance from the previous billing period, and divides the result by the number of days in the billing period.
- Adjusted daily balance: With this approach, the card company starts with your balance at the beginning of the billing period and subtracts any payments received during the billing period. This usually results in a lower sum, and thus lower interest charges.
- Beginning balance: This approach simply charges interest based on your balance at the beginning of the billing period, excluding any recent purchases.
- Ending balance: If a card company uses this method, interest is charged on the billing period's ending balance.
Interest Rate "Gotchas"
The interest rate you started with when you first got the card may not be the same one you're paying right now. That's because:
- Your rate can change over time: If your card sports a variable interest rate, and the prime rate jumps by one percentage point next week, you can expect your credit card's interest rate to increase by one percentage point, too.
- Your rate might go up if you break the rules: Sometimes rates will be hiked if you pay a bill late or earn a demerit in some other way, such as exceeding your credit limit.
- The "special offer" has expired: Cards will lure you with a low introductory rate that will suddenly jump after a number of months. Read the fine print to know what you're agreeing to.
Tip: The good news is that you can often get your rate lowered just by asking. A 2014 CreditCards.com survey found that about two-thirds of those who asked got their rate lowered. (It helps, of course, to be a good, reliable customer.)
Collecting interest payments isn't the only way credit card companies make money. There are other fees and charges you can face when using a credit card. For example:
- Annual fees: Many credit cards charge an annual fee of perhaps $75 or $100. There are plenty of cards with no fee, and they're preferable -- unless the card with a fee is offering sufficient benefits to outweigh the fee, which is sometimes the case.
- Late fees: Your credit card company will be delighted to charge you a fee every time you pay a bill late, so stay on top of payments, and perhaps automate them, too, if you can.
- Over-limit fees: If your credit limit is $3,000 on a card, and you charge something that puts your balance over the top, you'll likely get socked with a fee. Know what your limit is, and stay well below it, ideally spending no more than 30% of your overall limit.
- Foreign transaction fees: If you charge expenses abroad, your card might levy a fee of up to about 3%, though some cards waive such fees.
- Cash-advance fees: Getting a cash advance via your card will typically result in a fee, too.
The article How Do Credit Card Rates and Charges Work? originally appeared on Fool.com.
Selena Maranjian owns shares of American Express. The Motley Fool recommends American Express. The Motley Fool owns shares of Capital One Financial.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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