Interest Rate Basics

Interest Rate Basics

Learn about how interest rates affect how much interest you pay each month.

What the heck do all of those numbers on your credit card bill mean? You may know what interest rates are, but do you know how credit card interest rates are determined? Do you have a variable-rate, a fixed-rate, or a tiered-rate? I'll explain it all, and I'll tell you how to use that information to make sure that you?'e making some headway into paying off your debt. First and foremost, an interest rate is the percentage that your credit card company charges you on any outstanding balance. The Annual Percentage Rate (APR) is the amount of interest you pay on the balance of your credit card in one year's time. If you're credit card has an APR of 15% and you keep a consistent balance of $1,000 on your credit card, you pay over the course of one year $150 in interest.

There are three types of interest rates:

• Variable Rate: This interest rate fluctuates along with one of the Federal Indexes. The rate is usually a specific multiple of "the prime rate; the one-, three- and six-month Treasury bill rates; the federal funds rate; [or] the Federal Reserve discount rate."¹
• Fixed Rate: This rate is always one set percentage. For example, the 15% APR above. However, many cards have clauses that state they may change your fixed rate if you are late with a payment or if you bounce a check. You may want to look over that fine print again.
• Tiered Rate: Your interest rate changes with your balance. Usually the interest rate increases as your balance increases. I may pay a 15% APR as long as my balance is under $1,500 but when I hit $1,501 the rate can change to 16%. Again, check the fine print or call your credit card company's customer service department.

So, how do you make sure that you're working off your debt? Well, first figure out your monthly periodic rate. Chances are your credit card company charges you a daily periodic rate, but the formula I'm going to give you is much simpler and close enough to be accurate. Your monthly periodic rate is your APR divided by 12. The monthly periodic rate on my 15% APR is (approximately) 1.25%.

Multiply your balance by your monthly periodic rate. In my case I'll multiply my $1,500 balance by .0125 (the decimal equivalent of 1.25%). The result is $18.75, which is approximately how much interest I pay each month. Because credit cards use a daily periodic rate, the interest ends up being just a bit more around a dollar extra in my case.

Here's where you can get into trouble: If I pay my minimum payment of $20 each month and never any more and each month's interest is $19.75 then I'm paying my debt off one quarter per month. At that rate it would take me 6,000 months to pay off my $1,500 balance. Or 500 years.

This is how so many people get stuck in debt. You need to know how much interest you?re paying each month and you need to work off not just each month?s interest but also the debt.

A very basic but good rule of thumb: If you think you?re the type to have a large debt for a long amount of time, you might save money by using a credit card with an annual fee and a smaller interest rate. Look into whether a balance transfer will help you get your debt in control. There's no way around it though, you'll need to crunch some numbers.