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How Credit Card Interest Rates are Determined
The interest rate for a credit card is termed an annual percentage rate (APR). How your credit card interest rate is determined is explained in your card agreement. Your credit score can affect the rate you receive. If you have good credit, you will be offered the lowest APR available. You are also eligible for many credit card offers if you have fair to good credit. Someone with bad credit, though, will probably not pay the advertised APR. Instead, your bad credit could mean that you pay a higher interest rate, due to your status as a credit risk. You might also not qualify for low promotional rates and programs
Your credit card’s APR is likely to be either variable or fixed. A variable rate changes with market conditions, while a fixed rate remains the same, even if interest rates in general rise. Here is an overview of how these different rates are set:
Variable: In this case, your credit card interest rate is determined by a formula that takes into account the changing market. The credit card issuer will base the rate on an index that is it does not control. This may be the Treasury bill rate, or it might be the prime rate. Every so often, usually each quarter, the credit card issuer adjusts your APR, based on what is happening with its base rate. Many issuers figure credit card interest rates using a “prime plus” formula. This means that the credit card issuer will decide that your variable rate will be based on the prime rate plus a certain percentage more. If your rate is set using prime plus 11%, it means that every quarter, on a certain day, the credit issuer will look at the prime rate and add 11 points. So, if the prime rate is 1.99%, your interest rate will be 12.99%.
Fixed: Instead of changing with the markets, a fixed credit card interest rate will remain steady. Your credit card issuer will tell you want you can expect to pay, and if interest rates go higher, you are protected, as your fixed rate remains the same. If rates head lower, though, your interest rate will continue as it is, and you could lose out.
In addition to the basics of figuring your APR, it is important to note that credit card issuers might stipulate different APRs that can be applied to your account balance. Most of the time, the APR that credit card advertise, and the rate that is figured as variable or fixed, is the purchase APR. This is the interest rate you pay on balances that result when you use your credit card to buy products or services. Other APRs that you might encounter include:
Balance transfer APR: When you transfer a balance from another loan to your credit card account, you might pay a different rate of interest. Many credit card companies offer promotions that allow you to transfer your debt for a lower rate than your purchase APR. Be aware, though, that many balance transfers come with a one-time fee on top of the interest rate.
Cash advance APR: This type of APR is often higher than your purchase APR, since you are using your credit card to get cash from an ATM or bank branch.
Penalty APR: If you miss a payment, or pay late, or if the payment is returned to you because of insufficient funds, you can be charged a penalty APR. The penalty APR is often the highest APR charged by a card issuer, and can be devastating if you carry a high balance on your credit card.
Introductory APR: An introductory APR, or a special APR, is temporary. The credit card issuer offers you an especially low interest rate for a limited time, usually between six and 12 months. When the introductory period is over, your APR reverts to the regular purchase APR in most cases. You should note, though, that certain actions might trigger an end to your introductory APR and result in a penalty APR.
The Credit CARD Act of 2009 requires issuers to inform you when changes are being made to your credit card interest rate. You must receive 45 days’ notice before changes can take effect. This means that if the issuer decides to switch your fixed rate card to a variable rate, or change the formula for deciding how your variable rate is figured, you have to be properly notified. Note, though, that 45 days’ notice is not required if you trigger a penalty rate, if you get a cash advance or if the introductory rate is coming to an end. The law determines that you have been warned of these possibilities. (You will receive notice, though, if the penalty or cash advance APR on your account is changing, i.e., if the penalty rate for your card is raised from 25.99% to 29.99%.) If you are not happy with the new credit card interest rate, you can reject the change. Your account will be closed, and you can finish paying off the balance at the old interest rate.
How You are Charged Credit Card Interest
Credit card issuers use your APR to determine how much you owe in interest fees each month. Your interest is compound either on a daily or a monthly basis. This means that, at the end of each specified period, the interest is figured on how much you owe, and then added to your total balance. This means that your APR will be divided by the number of periods in question. If the interest is compounded monthly, your APR is divided by 12; if the credit is compounded daily, your APR is divided by 365. Here is an example:
You have an APR of 15.99%, compounded daily, on a credit card balance of $2,500. 15.99% / 365 = 0.0004381. Your balance ($2,500) is multiplied by 0.000438 to get $1.10 (rounded up to the nearest cent). The interest is added to your balance for a new total of $2,501.10. The next day, interest charges will be figured on this new balance, meaning that you pay interest on your interest, as well as on what you borrowed.
While it doesn’t seem like much, you can see how interest compounded daily starts to add up. Understanding how you are charged credit card interest can help you make better decisions about how you spend your money.