We’ve talked a lot about what credit is and what affects your credit score. But we haven’t yet touched on an important (and annoying) part of the whole credit ecosystem: Interest. Interest doesn’t just infiltrate your credit card payments; it also comes into play when making car payments or managing your mortgage. We’ve delved into what exactly is interest, but how does it work?
As a refresher: interest is the fee you pay for having the “privilege” of borrowing money from a lender, calculated as a percentage of the money you still owe. It may seem simple, but interest can be a really difficult concept to understand. In fact, when we surveyed Branch users about interest, about 74% misidentified interest.
Let’s break down some common misconceptions about interest. Understanding how interest works now can help you manage credit better in the future.
Misconception #1: Interest is charged annually, not monthly
It would be a lot simpler (and cheaper!) if interest were charged annually, because then it wouldn’t compound so quickly. But alas, interest compounds monthly.
People often (incorrectly) believe interest is being charged annually. That’s likely because when you see credit cards promote their products, they’ll give you the APR — the annual percentage rate.
APR = Periodic Rate x Number of Periods in a Year
So if your rate is 1% per period and there are 12 periods (months) in a year, your APR would be 12% because 12% = 1% x 12 months.
But the problem with APR is that it does not take into consideration compound interest.
Compound interest is paying interest on previous interest. As noted in our debt payoff blog, you’ll have to pay interest on the interest you still owe. And that can add up fast -- especially with credit cards that tend to come with the highest interest rates. But this leads us into the next misconception...
Misconception #2: You’re only charged interest if you don’t pay the minimum balance on your monthly bill
While paying the minimum balance is better than paying nothing because it helps maintain your credit score and works towards paying down your debt, paying the minimum balance does not get rid of the problem of compound interest.
If you don’t pay off the full balance each month, you’ll pay interest on the amount you still owe. So say you paid the $10 minimum payment on a total amount of $100 and now still owe $90. You’ll be charged interest on that $90. And then the next month, if you still only make the $10 minimum payment, you’ll pay interest on the interest you were charged from the month previously.
Moral of the story, try to at least make the minimum payment, but know that you’ll still have to worry about interest if you’re not paying the full amount.
Misconception #3: Interest starts accruing as soon as you purchase something with credit
This misconception is a little more complicated. Interest actually accrues monthly. If you always pay back the full amount you owe at the end of each period, you won’t have to worry about paying interest. But, this is only if you pay in full the prior month. As soon as you don’t make a full payment, interest will start accruing and will accrue immediately on new purchases if you’re behind. This is because the purchase will be part of the average daily balance (the calculation used by credit card companies to determine amount of interest due based on a customer’s daily balance within each billing cycle.) That’s why (if possible) it’s strongly encouraged to pay your balance in full each month.
Hopefully we’ve put these misconceptions about interest to bed so you can make smarter credit decisions. And if you’ve found yourself with a large amount of debt and interest, don’t sweat: learn about ways to pay down debt here.
This blog post is intended for general information purposes only and should not be considered legal or financial advice.