A Simple Breakdown of What Interest Really Costs You
July 11, 2017

A Simple Breakdown of What Interest Really Costs You

Education
HomeTown Bank Blog

It’s highly unlikely that, as a financially active person, you will be able to totally avoid accruing some sort of interest in your life time. After all, it’s one of the biggest incentives financial institutions have to lend consumers money. That’s why it’s important to have a true understanding of the costs of interest before you sign your next loan or apply for a new credit card.

Consumers experience interest in a variety of ways, most commonly through credit cards, loans, and even savings accounts. While interest rates and rules can vary dramatically between routes of credit, the core concepts remain the same. To keep things simple, we’ll focus on the type of interest most likely to sneak up on you in the form of debt: credit card interest.

How They Determine Your Rate

The biggest factor in deciding the interest rate a creditor will offer you is based on your potential risk as a borrower. Creditors will take into account your past credit activity, including the habit of timely payments, levels of debt, and any other incidents that could knock your credit score. If you’ve had financial trouble in the past, your interest rate will likely be higher to counteract any risk you prevent. If you’ve successfully paid your bills and maintained a reasonable amount of debt, your rate should be lower.

Most rates float between 10% for good credit and 29.99% for those with more troubled credit history.

If you haven’t checked in on your credit score and history lately, you may want to consider visiting Experian or Credit Karma online to check on your status.

How To Calculate Your Interest

APR stands for Annual Percentage Rate. This is the point of reference used by the majority of credit card companies and lenders. Simply put, APR is an indication of how much interest you will accrue over a year.

Imagine that you made a large purchase of $1,500 on your credit card, that has an APR of 21%. That should mean that you would just accrue $315 of interest on that debt over the next year. Unfortunately, that isn’t exactly how it works.

While you would naturally think about APR on a yearly basis, this interest is actually accrued every day. That’s why it’s important to calculate your daily periodic rate. To find this number, simply divide your annual percentage rate by the 365 days of the year. Keep in mind that some lenders work on a 360 day basis. You can find your lender’s preferred method of achieving their daily period rate in your lending agreement.

When working on your budget and trying to use your credit card mindfully, keep in mind that your balance will fluctuate as you accrue interest or put more on the card. That’s why you should consider yet another number, known as your average daily balance. If you have a low balance for 29 days then make a big purchase on the 30th day of the month, your credit card company would take the average between the two balances to find the average daily balance. Now let’s do the math.

You had $56 on your account for 29 days of the month. Then you spent that $1,500 on your card on the last day. So to get to your average daily balance you would take ($56 x 29) + ($1,500 x 1) then divide that by 30. Your average daily balance would be $104.13.

Now you take your average daily balance and multiply it by your daily periodic rate: $104.13 x 0.057. Then multiply the total of that by the number of days in your billing cycle. $5.99 x 30. So your interest accrued in that single month would be $179.73.

That’s a lot of math that most of us don’t have the time or energy to keep track of, but it’s exactly how your credit card debt can sneak up on you. Lucky for you, we have a credit card pay off calculator to help you plan your next payment!

Know When Your Interest Starts to Accrue

Many credit cards offer an introductory rate of 0% for six months to a year. So for the first chunk of time that you have your credit card, you can swipe freely, without worrying about extra cost. Just be sure that your balance doesn’t build up when your interest is getting ready to kick in or your next bill will be a bit of a surprise for you.

Furthermore, it’s important to understand how your interest accrues once your rate has already kicked in. If you pay your full balance every month, you may be able to take advantage of the grace period. This means that if your balance starts at $0 every month, when you make a new purchase and pay it off to $0 before the next billing cycle, none of that purchase will have accrued interest. It’s a great incentive to use your card for small purchases and also helps you build your credit! If you pay your balance after that grace period, the charges will accrue immediately.

Always Read Your Lending Agreement

Interest is a complex subject and can vary from lender to lender, but understanding how it works can have a major impact on how you manage your money. Be sure to read and understand the terms and conditions of any loan, credit card or bank account before singing the agreement. It may require some extra reading, math, and asking a few extra questions, but in the long run, you’ll be glad you did.

If you’re in need of some additional guidance when signing up for your next credit card, HomeTown has incredibly helpful bankers that can sit down and talk you through the process.