3 min read

how credit card interest rates work

Written By

Clay Shiffman

How credit card interest rates work in Canada

Interest rates are an important component of credit cards. When you borrow money from the credit card issuer for purchases, you face interest charges on the outstanding credit card bill.

Credit card interest rates play a pivotal role in determining the cost of carrying a balance and can significantly impact a person's financial well-being. Understanding credit card interest rates is essential for making informed financial decisions in Canada. With many credit card options available, you'll have more knowledge to navigate the complex landscape of spending and borrowing money.

From annual percentage rates (APRs) to introductory offers and variable rates, let's dive into the mechanics of credit card interest rates and gain crucial insights into managing debt and optimizing financial strategies.

What are credit card interest rates?

Credit card interest rates refer to the percentage charged by credit card issuers for borrowing money on a credit card. When you use your credit card but don't pay off the credit card bill in full by the due date, the remaining amount incurs interest. Interest rates vary depending on the credit card company, the cardholder's creditworthiness, and prevailing market conditions.

The interest rate is typically expressed as an annual percentage rate, which represents the yearly cost of borrowing on the card. Cardholders should understand their credit card's interest rate and how it applies to their balances to manage their finances and avoid unnecessary debt effectively.

How does credit card interest work?

Credit card companies calculate your credit card interest charges based on the outstanding balance and the card's interest rate. Here are the different components of your interest rate:

  • Monthly billing cycle: Credit card companies set a monthly billing cycle during which you can make purchases using your credit card up to your credit limit.

  • Grace period: Most credit cards offer a grace period. You can pay off your balance in full without incurring interest charges during this period.

  • Carrying a balance: If you don't pay off the full balance by the end of the grace period in the current billing cycle, the remaining balance carries over to the next cycle. The credit card company starts charging interest on the unpaid amount.

  • Interest calculation: Credit card interest is typically calculated on a daily basis using the average daily balance method. Your account's balance is summed and divided by the number of days in the billing cycle to get the average daily balance. The average daily balance is multiplied by the daily periodic rate to calculate the daily interest charge.

  • Compounding interest: The daily interest charges are added to get the total interest for the billing cycle. The total interest is added to your outstanding balance. You're charged interest on your original purchases, and the interest already accrued.

  • Minimum payment: Credit card companies typically require you to make a minimum payment each month, which includes any interest charges accrued during the billing cycle and a small percentage of the outstanding balance. If you only make the minimum payment, the remaining balance continues to accrue interest, making it longer to pay off your debt.

What's the difference between credit card interest and APR?

Credit card interest and APR are closely related but have slightly different meanings. Credit card interest refers to the actual cost of borrowing money on your credit card. It's the percentage charged by the issuer on outstanding balances you carry. Credit card interest is typically expressed as a periodic rate, such as a monthly or yearly credit card interest rate, and is applied to your average daily balance to calculate the interest charges for each billing cycle.

The annual percentage rate is a broader measure encompassing the interest charged on your balances and additional fees or charges associated with borrowing on the card. It can include annual fees, balance transfer fees, cash advance fees, and other expenses. APR represents the total cost of borrowing over a year, expressed as a percentage. APRs may also include promotional rates or introductory offers, which can affect the overall cost of borrowing during the period.

How do card issuers determine interest rates?

Short and long-term interest rates play a crucial role in our financial landscape. Financial institutions use the interest rates in Canada as a guideline for setting credit card interest rates. During periods of economic growth, interest rates may rise, while during economic downturns, interest rates may decrease. Inflation rates, unemployment rates, and changes in the monetary policy set by the Bank of Canada influence the interest rates we see.

Market conditions can also impact how credit card companies set their interest rates. Issuers may adjust their rates to attract new customers or retain existing ones. Offers with a lower interest rate or promotional APRs may incentivize customers to apply for a particular credit card.

What is considered a good credit card interest rate?

A good credit card interest rate typically falls within the competitive rates offered by reputable credit card issuers. The credit rate you get depends on your credit score. Individuals with excellent credit qualify for the most favourable interest rates. They may receive offers from credit cards with interest rates well below the competitive average.

Cardholders with good credit scores can also expect to receive competitive interest rates, though they may be slightly higher than rates offered to individuals with excellent scores. You may also be able to negotiate the credit card interest rate to receive a more favourable one.

Individuals with average credit scores may still qualify for a credit card with a decent interest rate but may receive offers with higher rates than those with higher credit scores. These rates can be closer to the national average or slightly above.

Individuals with poor credit scores may have difficulty qualifying for traditional credit cards. If they qualify, they may be offered cards with much higher interest rates or may need to consider secured credit cards, which require a security deposit and have higher fees.

What are the different types of credit card interest?

Credit card interest rates come in several different forms, depending on how you use your credit card:

  • Purchase APR: The purchase APR is the interest rate applied to purchases made with the credit card. If you carry a balance from one month to the next, you are charged interest on the amount of the purchase balance.

  • Balance transfer APR: This interest rate applies to balances transferred from another credit card. Balance transfer APRs can be lower than purchase APRs, especially during promotional periods, but may revert to a higher rate after the promotion ends.

  • Cash advance APR: The cash advance APR is charged on withdrawals made from your credit card at ATMs or via cash advance checks. These APRs are typically higher than purchase APRs and often begin accruing interest immediately without a grace period.

  • Penalty APR: This interest rate is triggered if you violate the terms of your credit card agreement, such as making a late payment or having a payment returned. The penalty APR can be significantly higher than the standard purchase APR and may apply indefinitely or for a specified period, depending on the issuer's policy.

  • Introductory APR: Some credit cards offer a lower interest rate for a specified introductory period, often 0%, on purchases, balance transfers, or both. After the introductory period ends, the APR typically increases to the standard purchase or balance transfer rate.

  • Variable APR: This interest rate can change over time, usually in response to changes in a reference rate like the prime rate. Variable APRs can apply to purchases, balance transfers, and cash advances, and the rate will fluctuate with changes in the reference rate.

  • Fixed APR: Unlike variable APRs, fixed APRs remain the same over time unless the issuer provides advance notice of a change. Fixed APRs provide more predictable interest costs, but are less common in today's credit card market.

Is credit card interest calculated daily, monthly, or yearly?

Understanding whether you have monthly or yearly credit card interest accumulation is important for your debt management. Credit card interest is typically calculated daily but expressed as an annual percentage rate (APR) and added to your account monthly. Here’s how it works:

  1. Daily Calculation: Credit card issuers generally calculate interest daily using the daily periodic rate. The daily periodic rate is derived from the APR by dividing it by 365 (or 360 in some cases). For example, if your APR is 18%, the daily periodic rate would be 0.0493% (18%/365).

  2. Average Daily Balance: Interest is usually calculated based on the average daily balance method. Each day, the issuer tracks your outstanding balance, adds up these daily balances for the billing cycle, and then divides them by the number of days in the cycle to get the average daily balance.

  3. Daily Interest Calculation: The daily periodic rate is then applied to the average daily balance to determine the daily interest charge. This daily interest is compounded, meaning each day's interest is added to the balance and included in the next day's interest calculation.

  4. Monthly Billing Cycle: Interest is calculated daily, but it is applied to your account and reflected on your monthly billing statement. At the end of each billing cycle, the total interest accrued over the month is added to your outstanding balance if you have not paid off the full amount.

Should you pay your credit card balance in full?

Yes, paying your credit card balance in full each month is generally a good financial management practice. It helps you avoid costly interest charges. Since credit card interest rates can be quite high, carrying a balance monthly can lead to significant interest charges.

Consistently paying your balance in full can also positively impact your credit score. Key factors in your credit score include payment history and credit utilization ratio. Paying in full keeps your credit utilization low and demonstrates responsible credit management.

Many credit cards offer rewards like cash back, points, and travel miles. By paying your balance in full, you can enjoy these rewards without them being offset by interest charges. Carrying a balance can sometimes lead to other fees, such as late payment fees or penalty APRs if you miss a payment.

Tips for minimizing credit card interest charges

Minimizing credit card interest charges is essential for maintaining financial health and reducing debt. The best way to avoid interest charges is to pay your entire balance by the due date of each billing cycle. You can take full advantage of the grace period that most credit cards offer.

If you don't pay the balance in full, try to pay more than the minimum amount. It reduces the principal balance faster, resulting in lower interest charges over time. Interest on credit card balances is often calculated daily. Making payments as soon as possible, even before the due date, can reduce the average daily balance and minimize interest charges.

Take advantage of credit cards that offer 0% APR on purchases or balance transfers for an introductory period. Utilize these offers to pay down your balance without accruing interest. Ensure you pay off the balance before the promotional period ends to avoid high interest charges afterward.

If you can't pay off the balance at once, consider making multiple payments throughout the month to keep your average daily balance lower. This can reduce the amount of interest you accrue.

Lastly, have a strong debt repayment strategy. Set up automatic payments so you don't miss paying off any credit card bills, and monitor your spending to ensure you use credit wisely and only for purchases you can pay off. Spending within your means reduces the chances of overspending your credit.

Do you get charged interest on your card if you pay the minimum?

Yes, you will be charged interest on your credit card balance if you only pay the minimum payment each month. When you pay only the minimum amount, the remaining balance carries over to the next billing cycle. Interest is then charged on this remaining balance. Since credit card interest is typically calculated daily based on the average daily balance, the longer you carry a balance, the more interest accrues.

Can you be charged interest after paying off your credit card balance?

Yes, you can still be charged interest after paying off your credit card balance due to a concept known as residual interest or trailing interest. If you carry a balance from one billing cycle into the next and then pay off the entire balance, interest can still accrue on the days between your last statement date and the date you make the payment. This interest is typically applied to the balance carried over from the previous cycle.

Even if you pay off the balance listed on your statement, interest might accrue in the interim period before your payment is processed and your next billing cycle starts. This residual interest appears on your next statement.

Manage your credit responsibly and avoid interest charges

Accumulating credit card debt is stressful and costly. It can be challenging to repay and may lead to a cycle of debt. We can assist you in managing your credit accounts responsibly, helping you build your credit profile and meet your financial obligations.

Our virtual credit card simplifies everyday spending. You can make purchases online and in-store directly from your phone while earning cash back rewards.

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Building your credit with KOHO gives you access to various credit tools, including free credit score reports. Understand why your score changes and get useful insights to help you improve.

Note: KOHO product information and/or features may have been updated since this blog post was published. Please refer to our KOHO Plans page for our most up to date account information!