How does credit card interest work? There is no getting around interest rates. Credit card companies depend on customers to pay interest on credit cards in order for the credit card companies to make money. The customer’s credit score plays and enormous factor in the interest rate received. Higher credit scores receive the best interest rates. It is important to make sure that the information of credit reports is accurate in order to receive the best rates. Banks and credit unions do not make money when customers do not repay debts as promised. Customers must understand how credit card issuers calculate interest in order to make the best financial decisions about credit cards.
Factors in Credit Card Interest-How Credit Card Interest Works
Not all credit card companies charge interest. American Express is one of the companies that require customers to pay off the entire balance before receiving the next bill. The majority of credit card companies use revolving credit in which customers must pay a minimum payment each billing period. Credit card companies usually require customers to pay 5% of the current balance or $10—depending on which is greater. Credit card companies calculate interest in a number of ways, including:
· Average Daily Balance
This method of calculating interest benefits the cardholder and the credit card company. The method is commonly used to calculate interest. The credit card companies calculate the daily balance on cardholder’s credit cards and add and subtract payments and charges as they happen. The average is calculated based on these daily totals multiplied by the monthly interest rate of the cardholder to determine the finance charge.
· Adjusting Balance
This method is the most beneficial to the cardholder. The finance charge is calculated by taking the previous statement balance, adding any new charges, subtracting the cardholder’s payment made, and multiplying the cardholder’s interest rate by this numbers.
· Previous Balance
This method of calculating the finance charge favors the card issuers. The credit card issuer multiplies the cardholder’s balance from the previous statement by the cardholder’s interest rate to calculate the interest charge. This method charges cardholders interest on a previous balance that has been paid down the previous month.
How Do Credit Card Companies Compute Interest?
An example of how credit card companies calculate interest will be provided using the average daily balance using a low interest rate. If a customer charges $200 in the middle of a billing cycle, the formula for the interest is 15 days at $0 + 15 days at $200 = average daily balance of $100 x 5% monthly interest = $5.00. The cardholder’s bill will be $205.00.
The next example will use a higher interest rate to calculate interest. If a customer charges $500 in the middle of a billing cycle, the formula for the interest is 15 days at $0 + 15 days at $500 = average daily balance of $500 x 20% monthly interest = $100.00. The cardholder’s bill will be $600.00.
Tips to Receive the Best Interest Rates
As stated previously, the best way to get the best interest is to have a good credit score. If cardholders currently have a credit card with a slightly higher interest rate but wish to receive lower interest rates in the future, the following are tips to follow:
· Limit Credit Inquiries
Credit issuers see multiple inquiries on credit reports as someone trying desperately to receive credit. Credit issuers are less likely to give good interest rates to someone in this situation.
· Keep Balances Low
Lenders want to know that potential cardholders are a low risk for default. A rule to remember is to keep credit card payments at 10 to 15 percent of monthly income. Cardholders with high balances are seen as a risk.
· Eliminate Unused Credit Cards
Credit issuers see unused debt as a problem since cardholders have the potential to max out the cards at any time. Close these accounts and have the accounts removed from credit reports.
· Maintain Excellent Payment History
Creditors report payment history to credit agencies. Poor payment history on a credit report may likely prevent cardholders from receiving low interest rates.
· Maintain Available Credit of Credit Cards
Do not have a balance of more than 50% on any credit card. Charge only what is necessary, and try to pay off the balance each month to eliminate additional interest charges. Credit issuers look at this information when pulling credit.
Interest rates depend on many factors that consumers may or may not be aware of when applying for credit. It is important to create the best-case scenario when trying to receive the best interest rate on a credit card. Follow these tips to a better interest rate.