Credit card interest makes a huge difference in how much consumers pay, and just going from a card with a high rate to one with a low rate can save millions of dollars. In this article we share six useful tips about credit card interest, including how different rates can rob you even on the same card, how credit card payments are applied and how to cut credit card interest payments. We also cover why it’s so important to read the fine print, and we point you toward some easy ways to lower interest payments by boosting creditworthiness.
1. Not All Credit Card Interest is Created Equal
Some experts recommend paying off debts with the highest interest first. Imagine a person who pays off all debt every month on a credit card with an interest rate of 12%. Now imagine that same person carries a $1,000 balance on a 36% card and avoids paying it off. That consumer will end up owing $20,000 more after 10 years than if he or she shifted the $1,000 balance to their 12% card. An individual who goes one step further and transfers the $1,000 debt to a new 0% card every two years will owe less still.
Some balance transfer cards offer introductory rates of 0% on transfers for the first two years. A consumer who transfers the $1,000 debt to a 0% card every two years will owe $2,000 less credit card interest even than the person who moved the debt to a 12% card.
That’s not the end of the money saving story though. Beyond interest rates, balance transfer cards generally charge a 3% fee to transfer a card balance. That means even if someone is diligent about transferring their balance every two years to a new 0% card, they’ll still pay $150 for the transfers. That’s 3% of $1,000 every two years, and that’s assuming they pay off the $30 transfer fee and don’t transfer it to the new card.
The person who pays the least for the $1,000 of credit card debt is the person who pays off their card balance every month. Here’s a breakdown:
|Situation||Leave Debt on High Interest Card||Move Debt to Low Interest Card||Transfer Debt Every Two Years to 0% Card||Pay Off Debt|
|Card Interest Rate||36%||12%||0%||None|
|Interest After 10 Years||$20,646||$2,106||$0||$0|
|Balance Transfer Fees||$0||$0||$150||$0|
|Total Cost of Debt||$21,646||$3,106||$1,150||$1,000|
2. Even on the Same Card, Credit Card Interest Varies
Some balance transfer cards that offer a 0% rate for transfers have different rates for new purchases. For example, the Discover It balance transfer card offers a 0% interest rate for the first 18 months on balance transfers, but only extends the 0% interest rate for the first six months on purchases. Someone who gets this card and starts using it for purchases while keeping the 18 month window in mind could be in for a nasty shock.
Some credit cards have higher interest rates for purchases from the start. A balance transfer credit card might charge 0% for transfers and 20% for purchases right away. Cards can also charge higher rates for cash advances and late payment amounts. The credit card companies keep a record of which debts are which in each credit card account, and they apply interest charges accordingly.
3. How Credit Card Payments Are Applied
In the United States, credit card issuers are required to apply everything above the minimum payment to the highest balance first.
Suppose a cardholder has a Bank of America MasterCard with $2,000 of debt from balance transfers and a 0% interest rate. Suppose that on the same card the cardholder also has $1,000 in debt from purchases with a 20% rate. If the card’s minimum payment is $35 and the consumer pays $200, the first $35 will go toward paying off the $2,000 balance transfer amount. The rest of the payment or $165 will be applied to the $1,000 purchase balance. That’s helpful because most of the payment went toward the more expensive 20% debt. That means the cardholder will pay less credit card interest in the future.
If the same person only pays the minimum $35 payment, the credit card company will apply the entire $35 payment to the debt with the 0% interest rate. As long as the cardholder keeps making only minimum payments every month, the payments will all be applied to the 0% interest balance transfer debt. That leaves the new purchase debt with the 20% interest rate untouched and creates higher overall credit card interest charges. This “negative payment hierarchy” on minimum payments is a big reason to pay more than the bare minimum every month.
4. Pay More Than the Bare Minimum to Cut Credit Card Interest Payments
Like we said above, minimum payments go toward the cheapest debt first, increasing credit card interest payments. Anything above minimum pays down the most expensive debt first, decreasing interest payments. Let’s take an example where a cardholder has a single credit card with $3,000 in debt. $1,000 is from balance transfers at a 0$ rate, $1,000 is from purchases with a 20% rate, and $1,000 is from cash advances with a 30% rate.
The cardholder makes only the minimum $35 payment for a full year. Since minimum payments go toward the cheapest debt, after a year there’s $580 in balance transfer debt on the card. With added interest, however, there’s now $1,200 in debt from purchases and $1,300 in debt from cash advances. The total on the card has actually gone up by $80 and the balance stands at $3,080.
|Debt on Same Card||Interest Rate||When It's Paid Off Making Minimum Payments|
|$1,000 balance transfer debt||0%||2.5 years|
|$1,000 purchases||20%||7.5 years|
|$1,000 cash advance||30%||never|
If the cardholder keeps making only minimum payments, the balance transfer debt is gone in about 2.5 years. But during that 2.5 years, the other debts have ballooned. The 20% debt is now $1,440 and the 30% debt is now $1,690. Even though the balance transfer debt is gone, the overall card balance has grown to $3,130.
It now takes five additional years of minimum payments to pay off the 20% debt. By then, the 30% debt has swelled to $3,712. This card balance just keeps growing. If the cardholder continues to make minimum payments, it is now impossible to pay off the card balance. The $3,712 will continue to grow in spite of the minimum payments.
By contrast, paying just $35 more per month, there’s now $20 a month attacking the most expensive 30% debt. At that rate, the 0% debt is gone in just over three years, the 30% debt is gone a few months later and the card is fully paid off in five years.
5. Understand Your Credit Card Interest Rates
Though it takes time, reading the fine print at the bottom of any credit card offer can make a difference of tens of thousands of dollars. That’s because most credit cards don’t have just one interest rate – they have several.
Bank of America’s Travel Rewards Card, for example, has a 0% interest rate on balance transfers and purchases for the first year. After that, the rate jumps to anywhere from 14.99% to 22.99%, depending on the credit worthiness of the applicant. That’s another reason to work to raise your credit score. The card also has a separate interest rate for cash advances, and up to a 29.99% rate on late payments. The card also adds a transaction fee of anywhere from 3% to 5% on purchases, balance transfers, and cash advances.
A consumer who knows his or her different credit card interest rates and how they work will avoid pitfalls, while one who doesn’t know the fine print can be in for a rough financial ride.
6. Credit Card Interest Rates Depend on the Consumer’s Creditworthiness
Even a single percent change in a credit card interest rate can make a huge difference. $1,000 that grows at 10% for 40 years earns $14,000 more interest than if the rate is just 1% lower. That means consumers should fight to get the lowest credit card interest rate they possibly can.
With typical credit card interest rates ranging from 10% to 25%, the possible difference on the same $1,000 over 40 years is an astronomical $7.5 million dollars. $1,000 that grows at 10% for 40 years is $45,000, but at 25% it’s well over seven and a half million.
Since a consumer’s creditworthiness determines their credit card interest rate, it’s vital to become as creditworthy as possible. Not doing so can cost millions.
Creditworthiness is made up of a mix of annual income, credit score and credit history. Credit score and credit history are affected by several factors, including whether the cardholder pays bills on time, how much available credit they use and how many credit cards they have. See our article on six surprising ways to hack your credit score.