How Does Credit Card Interest Work in Canada?
Everyone knows that credit card interest rates are among the highest of any borrowing product, outside payday loan companies, and other last-resort lenders. That’s why it’s so important to pay off your credit card balance in full each month.
But there’s more to credit card interest than the high rates. This article will cover other things about credit card interest, including the interest-free grace period and how cash advances work.
Interest-Free Grace Period
Before we get into the various ways credit card companies charge interest, it’s important to remember that you won’t pay any interest on a credit card if used properly. That’s because most credit card companies have a 21-day grace period between the time you make a purchase and when the credit card company begins charging interest. No interest will be charged as long as you pay off your balance in full within that grace period.
The grace period doesn’t include cash advances. A cash advance refers to the money you borrow from a credit card that doesn’t involve a purchase. Think of a cash advance as a short-term loan using your available credit. Most cash advances are made as cash withdrawals from an ATM or online transfers from your credit card to your chequing account.
The 21-day grace period does not apply with cash advances, and interest charges begin to accrue immediately. If you find yourself in a position where you have to make a cash advance, your best bet is to pay it off as soon as possible to avoid further interest charges.
Different Types of Credit Card Interest
Credit card companies charge interest in a few different ways, and if you’re not careful, you can end up paying an arm and a leg for convenient access to credit. Here’s a look at the different ways you can pay interest.
Credit Card Purchase Rate
The credit card purchase rate, also known as the annual percentage rate (APR), refers to the interest charged on regular purchases made with your credit. For most standard credit cards, the APR is around 19.99%.
Cash Advance Interest
As I explained earlier, the credit card company applies cash advance interest to money you borrow against your available credit card limit. This doesn’t include purchases made with the card. Cash advance interest is often at a higher interest rate than the regular purchase rate. For example, if a card’s purchase rate is 19.99%, the cash advance rate might be 22.99% or more.
You should avoid taking cash advances if possible because the interest begins to accrue immediately (no grace period), and there is usually a fee associated with the cash advance. – up to $5 or more each time.
Balance Transfer Interest Charges
Periodically, your credit card company may offer you a low-interest Balance Transfer. Balance transfers let you pay off another, higher-interest debt by transferring the balance owing to your credit card. The only caveat is that you have enough credit limit to move the funds over.
While you can initiate a balance transfer anytime, the periodic special offers usually come with a limited-time, low-interest rate. For example, your credit card issuer may offer you 0% interest on any balance you transfer over to the card for six months. If you’re currently paying 19.99% interest on a different card, it can result in sizable interest savings.
However, you do have to be careful. Most of the time, these offers require that you pay a one-time fee, often 3% of the total balance you’re transferring over. Using our example above, let’s say you transfer $5000. You won’t pay any interest on $5000 for six months, but you will have to pay a $150 upfront fee to complete the balance transfer.
The credit card company is betting that you won’t pay off the full $5000 over the next 6-months, and they’ll begin earning 19.99% interest on those funds once the interest-free period expires. Clever, heh!
Most credit card companies reserve the right to jack up your interest charges if you don’t operate the account as agreed. For example, if you have a habit of missing the minimum payment or your balance exceeds your credit limit, your interest rate can rise significantly. While it varies, you might begin paying more than 30% interest on your account.
How to Calculate Credit Card Interest
Credit card issuers calculate compounding interest daily. Here’s a basic example, using a $3,000 balance and a 22% interest rate:
Step 1. Determine the daily interest rate: 22% / 365 days = .0602%
Step 2. $3000 X 0.0602% = $1.80
The interest calculated for the first day is $1.80, increasing the balance owing to $3001.80. On Day 2, you would pay .0602% interest on $3001.80, instead of $3000. This is what’s known as compounding interest, or interest on interest. The pattern continued throughout the month unless you pay the balance in full.
The more credit card interest is left to compound at high-interest rates, the more difficult it becomes to repay the entire balance.
Low-Interest Credit Cards
Not all credit cards have high-interest rates. Many credit card companies offer low-interest cards, ideal for customers who regularly maintain a balance owing on their card. Most low-rate credit cards have an annual fee, as the lower rate is considered a benefit
If you plan to pay off your balance in full every month, there is no benefit to obtaining a low-interest credit card. Instead, I recommend a rewards credit card that will let you earn valuable cash back or points towards free gas or travel.
Final Thoughts on How Credit Card Interest Works?
As you can see, there are many factors to consider when it comes to credit card interest. But while it can all seem very complicated, the simplest way to deal with credit card interest is not to pay it. If you can, ensure that you pay your balance in full every month and avoid cash advances or over-limit fees and other penalties. If you have a large credit card balance and have difficulty managing the payments, consider paying off the debt via a consolidation loan.