Why Credit Card Interest Rate Is Not Just An Interest Rate

Credit card companies hope you want a credit card to shop until you drop, but they certainly don't want you shopping around for the best deal on them. In terms of borrowing money, to do so on a credit card is one of the most expensive ways possible. The interest rates on credit cards for the most part exceed those of student loans, mortgages, and car loans. Only payday loans are more egregious. It is the interest rate that you need to shop around for, but it's not the final rate you need to look at. It's how it's calculated that counts.

When you buy clothes in NYC, the first $100 spent is tax free. Say you go out and buy a dress for $280. When you pay tax, wouldn't you want to know if you are paying tax on the full $280 or just the $180 after the first $100 is tax free? The same goes for interest rates on credit cards. How you get nailed by a number followed by a percentage is important. A credit card's interest rate is that ominous number that carries around its fine print baggage wherever it goes. Not that anyone would want to read that fine print. But not doing so can cost you major money, because you might not realise that you're getting killed by what you thought was a benign interest rate. Because an interest rate is an interest rate, right? Really, now, you think credit card companies are that easy...

Your APR is your Annual Percentage Rate. In other words, APR=interest rate, and all credit cards must by law disclose their APR. But notice the word annual in that acronym. So to charge you your interest on that flat screen TV you just had to have but can't afford to pay off in full at the end of your billing cycle, the credit card company can't charge you an annual rate for a monthly charge. So instead they calculate the finance charge using the Periodic Rate, which is the APR divided by the number of billing cycles per year (usually 12). So let's say your $1000 flat screen was charged to a card with an 18% APR. 18 percent annually divided by twelve billing cycles in the year equals a Periodic Rate of 1.5%. This is what you are charged each billing cycle. Now the fun begins.

There are several ways to calculate the interest rate. The most common are Average Daily Balance Method, Adjusted Balance Method, and Previous Balance Method. To stave off head splitting boredom, I'll use our $1000 flat screen TV scenario as an example for each method. So for all the following examples you have a beginning balance of $1,000 on an 18% APR credit card, and pay $800 on the 15th of the month.

Average Daily Balance (most common)-

Balance $600 ($1,000 for 15 days, $200 for 15 days)

Finance Charge $9 ($600 x 1.5%)

Adjusted Balance (best)-

Balance $200 ($1,000-$800)

Finance Charge $3 ($200 x 1.5%)

Previous Balance (worst)-

Balance $1,000

Finance Charge $15 ($1,000 x 1.5%)

You can find a mathematical explanation of how credit cards calculate interest rates here, but suffice it to say that you need to read your fine print. Look online under terms and conditions, or just call the toll free number on the back of your card and ask what method your card uses for the calculation of finance charges. And while you're at it, make sure you have an interest free grace period of 25-30 days. Cards with grace periods are getting fewer by the minute, and frankly nobody should have one without a grace period. It shouldn't cost you to pay off your balance in full each month. I mean, just look at how much it could cost you not to...

photo by louder via flickr