How Paying a Credit Card and Credit Card Interest Work

This page will walk you through an example scenario of getting, using, and paying a credit card. Along the way, you’ll learn some common credit card terms and how your actions can impact your credit history.

Understanding this page will help you build credit history and avoid late payments. You will also learn about the grace period most credit cards have, which is like a month-long interest-free loan. After the example, you’ll learn more about how credit card interest is calculated.

Some aspects have been simplified so this generally fits most cards, but the specific terms of your card may vary from this example. Make sure you read and understand the terms and conditions of any card before you apply. If you have any questions or feedback on this page get in touch with the Ask button on the top right of any page.

Get Approved for the Credit Card – June 1

Important Numbers

  • Credit Limit: $1000
  • Available Credit: $1000
  • APR: 15.99%

New Terms

  • Account Opening Date – The date when you’re approved for the card and the account is opened. You should get the card in the mail within a few days or weeks of being approved, depending on the card or issuer.
  • Credit Limit – The size of the “loan” you have available to spend on your card. This is the maximum amount you can charge to the card before you pay anything back to the credit card company.
  • Available Credit – The amount of your Credit Limit you have available to use right now. Don’t make the mistake of thinking “available credit” means “store credit,” like when you have a gift card for a store! When you apply for a credit card you agree to pay back anything you legitimately spend on a credit card.
  • APR – APR stands for Annual Percentage Rate. It’s the percentage you’ll pay in interest over the course of a year on any credit card debt you don’t pay off. For example, if you have $1000 in credit card debt on a card for a year and that card has a 20% APR, you’ll pay a little over $200 in interest. It’s more than $200 because credit card interest usually compounds daily or monthly. We’ll discuss APRs and how interest is calculated later. Most cards have a grace period, which lets you avoid paying interest completely when you pay your bill in full each month. A credit card can be completely free or very expensive depending on how you choose to pay your bill.
Since you haven’t purchased anything on the card yet, you can still spend 100% of the Credit Limit, so your Available Credit is $1000.

Credit Report Impact

The Account Opening Date is reported to credit bureaus as part of this new account. This date can be used in calculating the average age of your accounts in credit scoring models, which generally favor older accounts. Your Credit Limit is reported to the credit bureaus.

Even though you can spend the full amount of your Credit Limit before you pay anything back does not mean you should. The percentage of your Credit Limit you’re using is a major factor in credit scores. Using a higher percentage is generally worse for credit scores, which is why maxing out your credit cards can quickly lower your credit scores. We’ll discuss this more later.

Make a $600 Purchase – June 22

Important Numbers

  • Credit Limit: $1000
  • Current Balance: $600
  • Available Credit: $400

New Terms

  • Current Balance – How much you owe the credit card company, based on up-to-date use of the card. This may also be known as your Outstanding Balance.

By making a $600 purchase on your card, your Current Balance increases to $600. Your Available Credit is the amount of your Credit Limit you still have available to spend after subtracting your Current Balance.

$1000 Credit Limit – $600 Current Balance = $400 Available Credit

Since your Credit Limit is $1000, your Available Credit is now $400.

Credit Report Impact

Nothing related to this event is reported to credit bureaus.

Statement Closing Date – July 1

Important Numbers

  • Current Balance: $600
  • Statement Balance: $600

New Terms

  • Statement Closing Date – The last day of the current statement period. This is the cutoff for charges and payments to count toward this statement period.
  • Statement Balance – On the Statement Closing Date, your Current Balance, minus any payments made, plus any extra fees charged by the credit card company, becomes your Statement Balance. Your Statement Balance will not change until the next Statement Closing Date.

Credit Report Impact

Your Statement Balance will be reported to the credit bureaus, and this is the balance that will factor into your credit utilization. In this case, you’re using 60% of your available credit ($600 balance / $1000 credit limit). 60% utilization is quite high. To maximize your credit scores, it’s best to use as low a percentage of your available credit as you can, although 1% utilization is technically better than 0%. You can also make a payment before the Statement Closing Date to lower the Statement Balance that’s reported.

Higher credit limits can make it easier to keep your utilization low. Occasionally, you may get a credit limit increase from your credit card issuer automatically when you’ve been using your credit card responsibly for a while. This can be great for your credit scores. You can also be proactive and request a credit limit increase from your bank.

Receive Statement (Mail or Online) – July 3

Important Numbers

  • Current Balance: $600
  • Statement Balance: $600
  • Minimum Due: $15
  • Due Date: August 7
  • Next Statement Closing Date: August 10

New Terms

  • Statement – A document you will get in the mail or can view online that provides details about the previous statement period. It includes the Statement Balance, Minimum Due, and Due Date.
  • Minimum Due – Minimum amount you must pay your credit card company by the Due Date to keep your account in good standing, even though you really owe the Statement Balance.
  • Due Date – The date, usually about 25 days after the Statement Closing Date, when a payment is due. For most cards, the Due Date is the same day of the month every month. Sometimes this is based on when you opened the card, but some issuers allow you to choose a different date on which your bill will be due each month.
  • Next Statement Closing Date – The new statement closing date for this current statement period that started after the previous Statement Closing Date on July 1.

The Minimum Due is calculated based on your Statement Balance according to the terms of your card. For this example card, we assume the terms are:

Minimum Due is calculated as 2% of the Statement Balance rounded down to the nearest $1. When the Statement Balance is above $15, the Minimum Due will be no less than $15.

The way credit card minimum payments are structured can be complicated and vary from card to card. The structure of a minimum threshold amount (like $15 or $25) for the Minimum Due that rounds to the nearest dollar or $5 is common. Since 2% of the $600 Statement Balance is $12, but the terms of this card say the minimum will never be less than $15 when the Statement Balance is above $15, the Minimum Due amount in this example is $15.

CAUTION: The Minimum Due is not the credit card company telling you the amount you should actually pay. To avoid credit card debt, you should pay the full Statement Balance. If you only pay the Minimum Due each month:

  • you will pay a significant amount of extra money to the credit card company as interest
  • paying off your debt will take much longer (possibly decades, or you may never be able to pay it off)
  • you may end up with lower credit scores due to high credit card balances

Credit card companies are not on your side when it comes to the Minimum Due. You may be tempted to only pay the minimum, or a slightly higher amount like double the minimum. Credit card companies stand to make the most profit from you as a customer if you pay less than the full amount you owe each month. When you pay the minimum or any amount less than you owe each month, it’s a sign you’re going into credit card debt.

It may appear that you’re paying 2% of what you owe when you pay the Minimum Due. So, you may think that if you don’t spend any more on the card you will have paid back 24% of what you owe after paying the minimum for a year (12 months x 2% = 24%).

However, during each month you carry a balance you’ll be charged interest on the balance you carry to the next month. Depending on the APR of your card, you may actually accumulate more debt each month when you only pay the Minimum Due. We’ll come back to minimum payments later.

Credit Report Impact

Nothing is reported to credit bureaus as a result of this event (the Statement Balance was already reported on the Statement Closing Date).

Make a $200 Purchase – July 15

Important Numbers

  • Current Balance: $800
  • Statement Balance: $600
Your Current Balance has increased by $200 to reflect how much you currently owe the credit card company. Your Statement Balance is the same as it was on the previous Statement, and won’t change until the next Statement Closing Date.

Credit Report Impact

Nothing is reported as a result of this event.

Pay $500 on Due Date – July 25

Important Numbers

  • Current Balance: $300
  • Statement Balance: $600

Since this statement period has not closed yet, the Current Balance becomes $300 (to reflect your $500 payment) and the Statement Balance remains $600, because that’s what you owed when the Statement for this previous period was generated.

If you don’t pay at least the Minimum Due by the Due Date, your payment may be considered late or missed. If a payment is more than 30 days late, it can have a HUGE negative impact on your credit scores for many years. Issuers will usually wait until a payment is at least 30 days late to report it to credit bureaus. Even if the issuer hasn’t reported the late payment to credit bureaus they may charge you a late payment fee, increase your APR to a penalty rate, or both.

It may look like the issuer is asking you to pay the Minimum Due. With most cards, you will pay interest (lots of extra money) to the credit card company if you pay less than the full Statement Balance you owe. Unlike in this example, you should pay the full Statement Balance by the Due Date to avoid credit card debt and interest payments.

When it comes time to pay your bills, keep in mind that you can easily avoid interest by simply paying off your entire account balance by the due date. This will help save you money and it’s good for your credit scores because it helps you keep balances low relative to your credit limits.

Credit Report Impact

At this point nothing is reported to the credit bureaus. If you were to pay less than the Minimum Due by the Due Date, you risk a late payment being reported to the credit bureaus, which can have a big negative impact on your credit scores for many years.

Statement Closing Date – August 1

Important Numbers

  • Current Balance: $300.92
  • Statement Balance: $300.92
  • Interest Charged: $0.92
  • Minimum Due: $15
  • Due Date: September 7

New Terms

  • Interest Charged – Fees charged by the issuer on debt you did not pay during the previous statement period.

There’s a lot going on here because the previous statement balance was not paid in full. This is where we start to see why credit cards can get so expensive.

Since the APR of this card is 15.99%, the Interest Charged is $0.92, but how was that calculated?

First, let’s figure out the amount on which you’re paying interest. Like many credit cards, this imaginary card loses its grace period when a statement balance is not paid in full.

There were $200 in new purchases during the previous statement period. Normally, this amount would have been interest-free during the grace period if the bill had been paid in full. Since the bill was not paid in full by the due date, interest accrued on the entire $300 balance, which included the new purchases ($200) and the previous statement balance that was still owed ($100).

The imaginary card in this example, like many credit cards, compounds credit card interest daily. That means every day, interest is calculated on the amount still owed at the daily interest rate. Most credit card issuer calculate the daily interest rate by dividing the card’s APR (15.99% in this example) by 365:

Daily Interest Rate (15.99% ÷ 365): 

0.0438%

Every day, the amount you owed was multiplied by this daily interest rate. Then, that amount of additional interest was added to the amount you owe.

Here’s what that looks like, broken down by day:

Date Additional Interest Owed Total Balance Owed
7/25 $300.00
7/26 $0.13 $300.13
7/27 $0.13 $300.26
7/28 $0.13 $300.39
7/29 $0.13 $300.53
7/30 $0.13 $300.66
8/1 $0.13 $300.79
7/25 $0.13 $300.92

In this short example, the additional interest owed each day is the same amount, and it $0.92 doesn’t seem like very much money. But remember: as the balance grows the additional interest owed grows, too. As you owe more, the additional interest you owe each day will grow substantially. More on this in the next section.

The new Minimum Due is $15. The terms of this card say that when the Statement Balance is above $15 the the Minimum Due is 2% of Statement Balance, with a minimum of $15. 2% of the Statement Balance is $6.02, but since that’s less than $15 and more than $15 is owed, the Minimum Due is $15.This gets added to the $300 Current Balance, so the new Statement Balance is $300.92 and will be reported to the credit bureaus.

Credit Report Impact

The new Statement Balance will be reported to the credit bureaus. Your issuer may periodically change the Credit Limit of your account. If your Credit Limit changes, your new Credit Limit will also be reported to the credit bureaus. Remember, your Credit Limit and Statement Balance are important factors that impact your revolving credit utilization, a major component of credit scores.

More About Minimum Payments and How Finance Charges Are Calculated

If you don’t use a credit card responsibly by paying the full statement balance each month, it’s easy to accumulate boatloads of interest quickly.

Where is your minimum payment really going?

Here’s an example to show why only making the minimum payment (or close to the minimum payment) can keep you in credit card debt for many years.

Let’s say you have a credit card with an 18% APR, your balance is $10,000, and the terms of the card say the minimum payment is 2%.

Keeping the numbers simple, we can approximate your first month’s interest charge is $150: $10,000 balance x (.18 APR / 12 months) = $150, so now you actually owe $10,150. 2% of that is $203, so your minimum payment is $203.

If you only pay the minimum of $203, most of that ($150, or  around 75%) is just going toward paying interest you accumulated over the past month. Even though you’re paying $203 to the credit card company, you’re really only paying $53 toward the balance you owed at the end of the previous billing cycle.

Some credit cards have APRs in the neighborhood of 24%. If you repeat this same example using that higher APR, the monthly interest is $200. Since the interest is the same as the minimum payment all of the payment is going to paying interest.

Think about how depressing that would be over the course of a year: you paid the credit card company $2,400 ($200 x 12 months) and you still owe the same amount you did a year ago.

If you were to increase the amount of debt in this same example, more credit card debt would accumulate each month because the minimum payment would not even cover the additional interest being added each month. You would be deeper in debt each month even though you’re paying the minimum.

How are finance charges calculated?

There are several different methods credit card companies use to calculate interest. The example above uses terms similar to many popular credit cards on the market today. To know exactly how interest is calculated on your credit card, read your cardholder agreement. There are few major themes you should understand about credit card interest first, then we’ll cover a few of the common methods used to calculate interest.

You’ll pay interest on interest you owe

With most credit cards, every time you carry a balance from one billing cycle to the next you’ll be charged interest on the amount you carry over.

The interest you’re charged is added to your balance. You can see this in the table in the example above. If you carry any of that balance into the next billing cycle, you’ll be charged interest on the remaining balance, including the interest the credit card company added to your bill last month!

This is called “compounding” — you’re charged interest on the entire amount you owe, including any interest owed, every time interest is calculated. This is why it can feel like credit card debt quickly snowballs into larger and larger amounts.

Even though an APR appears to be an annual interest rate, credit card interest is compounded more frequently, not just at the end of the year. Depending on how your credit card calculates interest, you may owe more money every day you carry a balance, not just every billing cycle.

Calculating Interest: Daily Balance Method

One common method for calculating interest is the daily balance method. Interest can be compounded either daily or monthly, depending on the terms of your card.

With this method, interest is calculated based on your every individual day’s balance.

If it’s compounded monthly, the balance of each day is multiplied by a daily interest rate at the end of the billing cycle and added up to result in your finance charge.

If it’s compounded daily, the interest is calculated and added to the balance each day, and then that balance is used for interest calculation the next day. This results in higher interest payments than when your interest is compounded monthly.

With both of these methods you’re effectively accumulating more interest every day that you carry a balance beyond your credit card’s grace period, and if it’s compounded daily you’re paying more interest on top of any interest you already owed the day before.

Here’s an example of the Daily Balance method with interest that compounds daily:

Since an APR is an annual rate, your credit card issuer will divide that number by 365 (or sometimes 360) to determine a daily interest rate. If your APR is 18%, for example, the daily rate would be 0.0493% (.18/365 = 0.000493).

Let’s say you have a $1,000 balance on your credit card that you carried over from the previous statement period.

On the first day you owe interest, the issuer will multiply your balance ($1,000) by the daily rate (0.0493%) to determine your interest charges ($0.49). Those interest charges are added to your balance, so you now owe $1,000.49.

The next day, they’ll do the same thing: multiply your balance (now $1,000.49) by the daily rate (0.0493%) to determine your interest charges ($0.49). Now you’ll owe $1,000.98.

On the next day, they’ll do the same thing again: multiply your balance (now $1,000.98) by the daily rate (0.0493%) to determine your interest charges ($0.49). Now you’ll owe $1,001.47.

At the end of the 30th day, you’ll owe $1,014.40, so you’re paying a total finance charge of $14.40 for the billing cycle.

Since we only followed this example for a few days, the amount of additional interest owed each day does not appear to change since it’s only increasing by fractions of a cent. However, over time, the amount you owe can snowball, because every day you don’t pay down your balance you are owing more interest on the balance (including interest that compounded on previous days).

Calculating Interest: Average Daily Balance Method

Other credit card issuers use a method called Average Daily Balance for calculating interest instead of the Daily Balance Method. That means they’ll average together your balance every day of the month, then multiply that by the daily rate and the number of days at the end of the billing cycle.

Let’s say you have a $500 balance entering the month, then pay $500 on the 16th day of a 30 day month. For the first 15 days of the month, your balance is $500. For the second half of the month, your balance is $0.

With this method, the balance on each day is added up, then divided by the number of days in the billing cycle:

(Day 1 Balance + Day 2 Balance + Day 3 Balance…Day 28 Balance + Day 29 Balance + Day 30 Balance) / number of days

If you do this math with a $500 balance for the first 15 days and a $0 balance for the last 15 days, you end up with an average daily balance of $250.

To calculate your interest fees for the month, your credit card issuer multiplies the average daily balance by the number of days by that daily rate of 0.0493%. In this example, when we multiply $250 x 30 x 0.0493%, the interest charge ends up being $3.70.

Residual Interest and When You Make Payments

With the Daily Balance and Average Daily Balance methods, you can end up with something called “residual interest.” This happens when you’ve already paid off your entire credit card bill after carrying a balance for a few months, but then you see an interest charge on your next statement.

This is exactly what’s being illustrated in the previous example: Even though the balance was $0 at the end of the statement period, there was still a finance charge. This finance charge on your next statement after paying off a card is the residual interest. It’s the interest that accumulated on those days in the first half of the month when you were still carrying a balance, before you paid it off.

When interest is calculated with the Average Daily Balance method or Daily Balance method, the day you choose to make a payment during your billing cycle matters. Ignoring additional purchases, if you make a payment earlier in your billing cycle, you’ll end up paying less in interest than if you make a payment later in the billing cycle. This is because your balance will be lower for more days of the cycle.

Looking at the same example as above, let’s move the payment to a different day and see how the interest charge changes.

If there’s a $500 balance entering a 30-day billing cycle, then you pay $500 on the 9th day, the balance is $500 for 9 days, then $0 for 21 days. This results in an average daily balance of $150, so your finance charge is only $2.22 instead of $3.70: $150 x 30 x 0.0493% = $2.22

In the same situation, let’s say you pay on the 21st day instead. The balance is $500 for 21 days, then $0 for 9 days. This results in an average daily balance of $350, so our finance charge is $5.18 instead of $3.70: $350 x 30 x 0.0493% = $5.18

Although the numbers aren’t very big in this example, it illustrates how you could end up paying a lot more in interest when you have high balances and you pay off debt later in a billing cycle.

Calculating Interest: Adjusted Balance Method

This method is much simpler to calculate, and can result in lower interest than the previous methods discussed, but it’s rarely used by credit card issuers.

With this method, you start with the balance at the beginning of your billing cycle, then subtract any payments you made during the billing cycle. New purchases are not added.

The resulting amount is multiplied by a periodic interest rate based on the APR and the number of days of the billing cycle to calculate the finance charge.

For example, let’s say the balance left over from your previous statement cycle was $1000, and some time during the month (it doesn’t matter when) you made a $500 payment. Now, there’s $500 left. Assuming the same 18% APR we’ve been using, the interest rate for a 30 day billing cycle is 1.5%: 0.18/12 = 0.015

$500 x 1.5% = $7.50, so your interest charge is $7.50, regardless of when you make a payment, as long as you made $500 in total payments throughout the month.

How Your APR Can Change

There are a few ways your APR can change. Based on these examples, you can now see how even a slight increase in APR could instantly start costing you more money if you’re carrying a balance.

Changes to the Prime Rate

First, almost all credit cards have variable APRs. These APRs are tied to the Prime Rate. The Prime Rate is 3 percentage points higher than the federal funds rate, which is a rate set and changed by the Federal Open Market Committee, an organization within the Federal Reserve system.

The Federal Open Market Committee meets periodically throughout the year to decide whether they should change the rate or keep it the same. If they decide to increase it by 0.25%, for example, the APRs on credit cards with variable APRs will go up by 0.25%. If you’re carrying big balances on credit cards, you’ll see your interest changes go up slightly.

Unless you’re on the FOMC, fed rate changes are out of your control. Instead, focus on paying your credit cards off in full each month so you can avoid carrying a balance and the interest that goes along with that.

Changes to Your Credit History

The APRs of your credit cards are often set based on your credit history. Generally, the better your credit history is the lower your APRs will be. If your creditworthiness changes, your credit card issuer may change the rate.

If you start making late payments or go over your credit limit, for example, your credit card issuer may raise your APR. There is often a Penalty APR that is much higher than the regular APR, and can be triggered based on specific actions according to the terms of your card.

Due to the CARD Act of 2009, credit card companies aren’t allowed to change your APR on existing balances. However, they can change the APR for any new balances going forward. So, a penalty APR won’t apply to an amount you already owe, but will apply to future charges to the card.

Credit card issuers will periodically check your credit history. Even if you have not missed a payment on a specific card, that issuer may see that you’re missing payments on other cards and choose to increase your APR going forward.

Share this Guide with Someone

Luckily, you’ve just finished reading this guide, so you know how credit card interest works and how you can avoid it completely with most cards by paying your statement balance in full. If you found it helpful, please share it with someone else!

If you have any questions about anything discussed on this page, contact us and ask any time.

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