Interest on credit cards: How does it work?

Credit card interest

Australia’s love affair with credit cards is well documented. As at the end of August 2018, the RBA reports that the total outstanding credit card debt in Australia is around $51.5 billion. Around $32.2 billion of this debt is being charged interest.

With over 16 million credit cards in Australia, this puts the average interest-accruing credit card debt at over $2,000.

To many Aussies, credit card interest can seem complicated, and many institutions don’t make it explicitly clear how they calculate what you owe.

The key to avoiding things like interest repayments is to understand them, so we’ll go through how credit card interest works, and how you can cut down on it.

So how is credit card interest calculated, exactly?

Basically, there are three key components of credit card interest:

  • The annual percentage rate (APR): the stated interest rate on your card
  • The daily rate: your APR divided by 365 days e.g if your interest rate was 15% (0.15) your daily rate would be 0.04% (0.0004)
  • The average daily balance: the balance in your account for the month, times the number of days in that month

To sum it up in a simple formula, interest = daily rate (%) x average daily balance x number of days in the month.

Example: 

Let’s say you spent $1,000 in the month of January, which has 31 days. Your credit card has an interest rate of 14%, which is 0.0383% after dividing it by 365 days.

Therefore, your monthly interest repayment is:

= 0.000383 x $1,000 x 31

= $11.87

Now nearly $12 a month doesn’t seem like much, but credit card interest doesn’t mean that’s all you have to pay. Your monthly interest repayments will be added to your total outstanding balance, meaning it’ll add up the longer it takes you to pay off your debt.

Month # of days  Minimum monthly repayment of 2%(or $20, whichever is greater) Monthly outstanding balance  Monthly interest charged 
January  31  $                                                                        –  $                                             1,000.00  $                                           11.87
February  28  $                                                                 20.00  $                                                 991.87  $                                           10.64
March 31  $                                                                 20.00  $                                                 982.51  $                                           11.67
April  30  $                                                                 20.00  $                                                 974.17  $                                           11.19
May  31  $                                                                 20.00  $                                                 965.37  $                                           11.46
June 30  $                                                                 20.00  $                                                 956.83  $                                           10.99
July 31  $                                                                 20.00  $                                                 947.82  $                                           11.25
August 31  $                                                                 20.00  $                                                 939.07  $                                           11.15
September 30  $                                                                 20.00  $                                                 930.22  $                                           10.69
October 31  $                                                                 20.00  $                                                 920.91  $                                           10.93
November 30  $                                                                 20.00  $                                                 911.85  $                                           10.48
December 31  $                                                                 20.00  $                                                 902.32  $                                           10.71
Total   $                                         133.04

Note: According to ASIC, the commonly accepted minimum repayment is between 2-3%, or a set dollar value of around $20, whichever is higher. In this instance, $20 was higher than the minimum repayments. 

So you can see in this example, a year’s worth of interest repayments assuming the minimum amount is repaid each month is equal to just over $133 – that’s in addition to the $20 you’ve paid back each month. But, you still have more than $900 of debt to pay off, meaning you’ll still be paying interest for years at that rate. By only paying the minimum each month, ASIC’s calculator shows that it would take you six years and four months to pay this debt off in full, paying $1,509 in total.

If you make higher repayments each month, then you can work towards paying this debt off faster with less interest. Let’s see the difference if you to make monthly repayments of, say, $50:

Month # of days  Monthly repayment of $50 Monthly outstanding balance  Monthly interest charged 
January  31  $                –  $                                               1,000.00  $                                             11.87
February  28 $50  $                                                   961.87  $                                             10.32
March 31 $50  $                                                   922.19  $                                             10.95
April  30 $50  $                                                   883.13  $                                             10.15
May  31 $50  $                                                   843.28  $                                             10.01
June 30 $50  $                                                   803.29  $                                               9.23
July 31 $50  $                                                   762.52  $                                               9.05
August 31 $50  $                                                   721.58  $                                               8.57
September 30 $50  $                                                   680.14  $                                               7.81
October 31 $50  $                                                   637.96  $                                               7.57
November 30 $50  $                                                   595.53  $                                               6.84
December 31 $50  $                                                   552.38  $                                               6.56
Total   $                                           108.93

You can see the difference here. By the end of the first year you would have nearly halved your credit card debt, while paying less in interest. By keeping this up, you’d have paid it off in its entirety over one year and 11 months, saving a total of $379.

These examples assume that you don’t add anything extra to your credit card balance over this time, which may be unlikely depending on your spending habits. Spending an extra $500 would add to your outstanding balance, which in turn would increase your interest repayments. But you get the general idea: higher repayments = less interest and less time.

How interest-free days work

A common misconception with credit cards is that you’re charged interest on every purchase. Ultimately it’ll come down to the amount of interest-free days the card has.

Interest-free days on credit cards are a set number of days in which you won’t be charged any interest, provided that you pay off your monthly balance in full. This part is important to understand, as not paying off the balance in full means you’ll be charged the usual interest rate on purchases made during that period.

A glance at the current market shows that the maximum number of interest-free days offered by credit card providers is 62, although a more common number is between 44-55. Make note of the word ‘maximum’ – this is the highest amount of interest-free days you can get, but might get less depending on when you made the purchase.

Let’s say you have a 55-day interest-free credit card, and buy a TV on day 20 of that statement period. This means you have a further 35 days to fully pay off this balance before you’re charged interest on the purchase. If you were to buy the TV on day one, then you would get the full 55 days. Still following?

At the other end of the spectrum, there are credits card offering 0 interest-free days, meaning you’ll always be charged interest on every purchase, even if you paid off the balance at the end of the month. Such cards might try to hide this fact behind a low interest rate, but don’t be fooled. The lack of interest-free days can be more expensive overall, even with the lowest rate card available.

Want to not pay credit card interest?

There are really only two ways to not pay credit card interest, but only the latter of them is long-lasting:

  • Utilising 0% introductory purchase rates, which only last for a limited time
  • Paying off your monthly account balance in full every time.

So you’ll need discipline; leaving even the smallest amount in your account unpaid means you’ll be charged interest. Check your statement to see when each payment is due and make sure don’t leave any amount behind, if you can. If your provider allows it, set up a direct debit on or before the due date directly from your bank account to remove a lot of the admin that comes with paying credit card bills.

The different types of credit card interest rates

In addition to the purchase rate, which is what we’ve been discussing above, there are three other types of common credit card interest rates:

  • Promotional interest rate
  • Cash advance interest rate
  • Balance transfer interest rate

The promotional interest rate

Promotional (introductory) purchase rates are special interest rates offered for a limited period of time, normally straight after opening a new card. They’re also known as honeymoon rates, as the lower rate ends after a certain period of time.

A quick scan of the market shows that these honeymoon rates are as low as 0% and can last for up to 15 months.

The cash advance interest rate

A cash advance interest rate is the rate charged on cash transactions, such as ATM withdrawals or cash-out at shops. The interest rates on these withdrawals are often higher than the standard purchase rate (usually around 21%), and unlike the other rates here, they will always be charged interest from the moment they’re made.

Cash advances also incur a cash advance fee, a flat rate or percentage based on the size of the cash advance.

The balance transfer interest rate

Balance transfers involve transferring existing credit card debt onto a new one at a lower rate in order to pay it off. The balance transfer rate is the rate charged when you do this.

While balance transfer interest rates are often 0%, this is only for a period of time (up to 26 months). If you fail to pay off all of the debt by the end of the stated period, you’ll be charged interest at the revert rate.

Savings.com.au’s two cents

Credit cards are useful for making purchases without having the cash available at that very moment, but too many people seem to fall into the trap of using their credit cards too often, leading to amounts that they’re unable to pay off in full every month. Unpaid credit card balances lead to interest being charged, and the longer you leave that unpaid debt the more interest you’ll have to pay. For people who continue to spend on their credit cards each month even with debt, the interest owed can stack up to dangerous levels.

To minimise the bill on your credit card statement, try using your debit card for non-essential spend, as money you’ve already earnt won’t be charged interest. Things like lunches, coffees and other irregular daily expenses can be bought with the money that’s in your bank account, while recurring bills like electricity, petrol and groceries can stay on your credit card. This is just one tactic that you can use, but you could see a noticeable difference by not putting everything on your credit card.

If this isn’t an option, then you should at least try and pay more than the minimum allowed repayments unless absolutely necessary. Doing so could make a substantial difference to what you owe.

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