Over 175 million Americans have at least one credit card, according to the Consumer Financial Protection Bureau (CFPB). This financial resource is used both as a lifeline for emergency expenses and as an everyday tool to pay for transactions completed in-store and online.
With the availability and utility of credit cards, it’s important that you understand how credit card interest is assigned to a cardholder, how it works, and how you can potentially lower the rate. Lower rates can help you pay off your credit card debt with as little interest expense as possible.
How credit card interest works
- Check your credit
- Negotiate with the credit card company
- Use an alternative option: Balance-transfer credit card
How credit card interest works
When you take out a credit card, you’re charged to open and use the account. You may hear the terms “interest rate” and “APR” used interchangeably when referring to how much extra you’re charged when you carry over an unpaid balance from one month to another. To know how interest works, you need to know how it differs from APR.
The interest rate is the price you pay to borrow money. Interest is just the percentage charge that you incur for borrowing, without any other associated costs.
The annual percentage rate, or APR, of your credit card is the interest rate plus all fees associated with using the card throughout a one-year period. The CFPB mentions that the APR allows a consumer to compare the total costs of a credit card with another financial resource like a personal loan on a 1:1 basis.
There are a variety of factors that both drive interest rates in the industry and determine interest rates for the individual credit card holder. The CFPB cites falling charge-off rates from the Federal Reserve, the rise of new credit card accounts for borrowers with subprime credit scores, historically low prime rates, and credit card profitability for the general increase in rates.
When it comes to setting an interest rate for individual card holders, two main factors may be considered: the prime rate and your individual credit profile.
The prime rate is how much banks charge each other for short-term loans and is a reference rate for many types of consumer loans such as personal loans and credit cards. Banks may use the prime rate then increase it by a percentage to turn a profit.
Regarding your individual credit profile, a bank may consider factors like your credit score, your credit report, and the type of card you’re trying to secure. Although interest rates may vary by a seemingly small percentile, it’s important to know how drastically your interest costs can go up with a small increase.
| For example: Let’s say that three credit cards each have a $10,000 balance that the cardholder wants to pay off in 12 months. |
The first card has a 5.00% APR: its monthly payment will be $856 and $273 in overall interest will be paid. The second card has a 10.00% APR: its monthly payment will be $879 and $550 in overall interest will be paid. The final card has a 15.00% APR: its monthly payment will be $903 and $831 in overall interest will be paid.
Even though the monthly amount due increases by less than $50, a 10-point rise in APR leads to paying three times the interest. So it’s imperative to secure as low of an APR as possible.
1. Check your credit
You’ll need to check your credit report if you’re trying to get the lowest rate on your credit card. Checking your score is one of the easiest ways to begin your credit review, as many banks and credit card companies provide you with a FICO score for free.
FICO credit scores can range from less than 580 (poor), to 580-669 (fair), 670-739 (good),740-799 (very good) and more than 800 (excellent). If you can improve your credit score to the next-highest tier, you may qualify for a lower rate.
Along with your credit score, you should also check your credit report to identify any errors or mistakes. These issues, though inaccurate, can make your credit profile seem riskier than it is. Resolve these issues and restore your creditworthiness to its actual level before you apply for a credit card, if possible.
| Good to know: Even though you may comparison shop and find credit cards that claim to offer low APR rates, those rates may be reserved for applicants with specific credit scores and histories. |
Improve your credit score
You can improve your credit score with the following tips:
- Pay all of your bills on time and do not miss or delay a payment.
- Keep a healthy debt-to-credit ratio by not maxing out your credit cards.
- Don’t close credit card accounts that you’ve had for years even if you don’t use them frequently; this long credit history can help improve your score.
- Resist applying for credit cards frequently, as these credit checks appear on your credit report.
- Ask for your free credit report review from the three major credit bureaus each year to ensure it’s free of errors.
Although your credit score won’t improve overnight, it can increase by a few points from month to month, helping you reach the credit tier you need to secure a lower interest rate.
2. Negotiate with the credit card company
You also have the option of trying to negotiate a lower rate with the credit card company. Before asking them to reduce the rate, do your due diligence and consider which new rate would be considered fair. You can research and compare other credit cards until you’ve found a similar card with a lower rate.
Use this competitive information as the basis for why you’re requesting a lower rate. If you’ve stayed consistent with your payments, or secured the credit card through your longtime financial institution, be sure to mention that.
You may also want to consider asking if your interest rate or your minimum monthly payment can be temporarily lowered. Some credit card companies offer hardship programs designed to help borrowers struggling to repay their debt. This may be an option for borrowers who don’t have the credit history to justify a permanent rate decrease.
3. Use an alternative option: Balance-transfer credit card
Instead of lowering the interest on your current credit card, another option is to transfer your current balance to a different credit card with a lower interest rate. Known as a balance-transfer card, this single credit card replaces your current credit card(s) by taking on your outstanding balance.
The majority of balance-transfer cards offer a low or even 0% APR for the first year or longer. The goal is to use these low rates to pay down your principal without accruing more interest. Some cards charge a balance transfer fee, which could be a flat rate of a percentage of the amount transferred. To determine how much you should pay monthly to decrease your debt by the end of the introductory period, divide your balance by the amount of months you’re being offered the 0% APR.
| For example: Let’s say your new balance-transfer card offers 0% APR for 15 months, and you have a balance of $3,000. Divide $3,000 by 15 months, which comes out to $200. By the time you reach the end of the introductory period, you will have paid $0 in overall interest, and paid off your credit card debt. |
It’s important that you pay off your transferred balance before the 0% period ends and the standard rate is applied. Even an increase of a few percentage points can cost you significantly in interest. Additionally, it can be tempting as your balance opens up to use the card, but make sure not to use it while you pay it off.
Check Out: What is credit card debt consolidation?
