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Types of credit card interest rates and how they work

For the privilege of buying things on credit, you will be required to pay interest. The amount you pay depends on the size of your credit card balance.

The annual percentage rate

The interest rate is a charge that you will pay on any balance that is still open on your card.

This rate is called the annual percentage rate (APR). It is the rate that you would pay over the course of a year, not what you would pay each month. What you pay each month is 1/12 of the APR; thus, if your annual percentage rate is 12%, you will pay 1/12 of that each month, which is 1%.

Variable rate

Most credit card APRs are variable, meaning that they change.

They are tied to a specific foundation interest rate, such as the Prime Rate, a rate that banks charge to their most creditworthy customers. Added to the Prime Rate is the card's own rate, so that the result is noted like this example: Prime + 6.9%.

The variable rate can change as the Prime Rate changes periodically. The way it changes will be described in the credit card agreement that comes with your card.

Most credit card companies still offer grace periods, in which the interest that normally accumulates is waived if you pay your bill in full each month. Savvy card owners like to ensure that their cards have grace periods.

MIAMI - MAY 20:  Alain Filiz shows off some of his credit cards as he pays for items at Lorenzo's Italian Market on May 20, 2009 in Miami, Florida. Members of Congress today passed a bill placing new restrictions on companies that issues credit. The vote follows the Senate passage of the bill, which now heads for President Obama's promised signature. The bill will curb sudden interest rate increases and hidden fees, requiring card companies to tell customers of rate increases 45 days in advance. It will also make it harder for people aged below 21 to be issued credit cards.  (Photo by Joe Raedle/Getty Images)
A man shows off some of his credit cards in Miami, Florida in 2009. (Photo: Joe Raedle/Getty Images)

How interest is calculated

Interest is calculated on your balance in a number of different ways; the method used is identified in your account statement.

The balances used are these:

  • Average daily balance. With this method, your credit card company adds up each day's balance in the billing cycle and averages all of them.

  • Beginning balance. With this method, your credit card company uses the balance at the beginning of the billing cycle. This means that any purchases and payments made during the month do not factor in.

  • Adjusted balance. With this balance, any payments you make during the month are subtracted from your beginning balance.

  • Ending balance. The credit card company uses the balance at the end of the billing cycle. This means that any purchases and payments made during the month do factor in.

A word about double-cycle billing: Double-cycle billing calculates interest by taking the average daily balance from the previous billing cycle and factoring it into the current one, thus using two billing cycles instead of one. The recent Credit Card Act bans this.

And a word about trailing interest: Also called residual interest, this is interest charged when the card company reaches back into your previous billing cycle and charges interest on balances already paid off. So, if you charged $2,000 and then paid off $1,999 during the grace period, on the next billing cycle you will be charged interest on the full $2,000. This practice is not used by all card companies, however.

APRs and how they work

Know the types of credit card Annual Percentage Rates (APRs) and how they work.

Promotional (introductory) interest rate

Also called a teaser rate, this is a low or zero rate designed to attract new customers.

The promotional rate may apply to purchases, to balance transfers, or to both. Only in rare cases does it apply to cash advances. The promotional rate lasts only a certain amount of time, after which it rises to the regular APR.

But if you should unfortunately make a late payment during the introductory period, the card company has the right to end the promotional rate and increase it to the default rate. Situations like this are spelled out in the credit card agreement.

Regular APR

This rate is the regular rate you are charged for purchases, cash advances, and balance transfers. Each of these uses may have its own regular APR.

Default APR

The default rate is a higher rate that kicks in if you violate some aspect of the credit card agreement.

Violations include going over your credit limit, making a payment late, and other actions spelled out in the card agreement. The default rate can also be activated if you default on debts to another creditor. This is called universal default, and it applies only to future balances.

Though this may seem unfair to the cardholder, the company's rationale is that it wants to identify high-risk cardholders and cover its risk accordingly. Because default APRs are quite high, cardholders would be wise to make their payments on time and keep an eye on their balances.

Tiered APRs

These are different rates for different levels of balances. For example, a card with tiered APRs may charge 15 percent on balances up to $2,000 and 14 percent on any balance above that. Tiered APRs are rare.

Dive Deeper: Credit cards: Everything you need to know about how they work

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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