Credit Card Interest

Credit card interest is one of the most important means through which credit card issuers generate revenue. A card or an account number is issued by a bank or credit union which enables a consumer (the cardholder) to use it with various payees, making payments and borrowing money from the bank at a same time.

The bank will make the payment to a payee and then charge the cardholder an interest over the time the money remains borrowed. Banks have to bear losses when cardholders fail to pay back the borrowed money as agreed.

Accordingly, it is imperative for banks to calculate the interest based on any information based on cardholder’s credit risk – which is significant for the card issuer’s profitability. Before deciding what interest rate to offer, banks normally check national, and international records of applicant (if applicable), credit bureau reports to find out the borrowing history of the card holder applicant with other banks and carry out detailed interviews and  check records of the applicant’s finances.

Interest Rate Applicable

Interest rates on credit cards differ widely. In some cases, credit card loans are secured by real estate, and the interest rates can be as low as 6 to 12%.

Normally interest rates on credit cards ranges between 7% and 36% in the U.S., depending mainly upon the bank’s risk evaluation techniques and the borrower’s credit history. In Brazil, interest on credit card is among the highest in the world, in 2006, it was around 50% over that of most developing countries, which average about 200.

According to Economists, in 2006, a Brazilian bank-issued Visa or MasterCard to a new account holder m carried an annual interest as high as 240%; although, inflation was less than 10% per annum.

Interrelated fees

Even though charging interest over credit card borrowings serves as the principal way to generate revenues, banks also make other fees that interrelate with interest charges in complex ways.

(Banks make a profit from the entire combination, which includes transactions fees paid by merchants and cardholders, and penalty fees, such as for borrowing over the preset credit limit or for failing to make a minimum payment on time)

The proportion of credit card account income that comes from interest vary among banks (depending upon their marketing mix)

For example, in the U.K. a card issuer generates between 80% and 90% of income from interest charges. While remaining 10% is made up from default fees.

Laws

Many nations restrict the amount of interest that can be charged (often refereed as usury laws). Most countries strictly control the method in which interest rates are agreed, calculated, and disclosed. Some countries (particularly with Muslim influence) forbid interest being charged at all (and other methods are used, such as an ownership interest taken by the bank in the cardholder’s business profits based upon the purchase amount).

United States

Credit Card Act of 2009

This statute covers numerous aspects of credit card contracts, including the following:

• Limits over-the-limit fees to cases where the user has given consent.
• Limits interest rate increases on past balances to cases in which the account has been over 60 days behind the scheduled payment date.
• Limits general interest rate increases to 45 days after a written notice is offered, permitting the consumer to opt out.
• Needs further payments to be applied to the highest-interest rate sub-balance.

Methods of Charging Interest Rates

Annual Percentage Rate

The majority U.S. credit cards are quoted in terms of nominal annual percentage rate (APR) compounded on a daily basis, or sometimes on a monthly basis, which in either case is not the equal as the effective annual rate (EAR).

Average daily balance

The total of the daily outstanding balances is divided by the number of days covered in the cycle, in order to calculate an average balance for that period. This amount is then multiplied by a constant factor to give an interest charge. The resultant interest is the same as if interest was charged on a daily basis, except for the fact that it only compounds (gets added to the principal) once per month. It is the most uncomplicated of the four methods since it calculates an interest rate approximating if not precisely the same as the expected rate.

Adjusted balance

Under this method, the balance remaining at the end of the billing cycle is multiplied by a factor so as to give the interest charge. This might effect in an actual interest rate lower or higher than the expected one, since it does not consider the average daily balance, or more specifically, the time value of money actually lent by the bank. However, this method does consider the money that is left lent out over several months.

Previous balance

Exactly opposite happens in this method: the balance at the beginning of the preceding billing cycle is multiplied by the interest factor so as to derive the charge. Just like the” Adjusted Balance method”, this technique can result in an interest rate higher or lower than the expected one, however the part of the balance that carries forward for more than two full cycles is charged at the expected rate.

Two-cycle average daily balance

In this method, the sum of the daily balances of the preceding two cycles is considered, but interest is charged on that amount only over the present cycle. This might result in an actual interest charge that applies the advertised rate to an amount that does not correspond to the actual amount of money borrowed over time, which is very much dissimilar that the expected interest charge.

Daily accrual

The daily accrual method is commonly used in the UK. The annual rate is divided by 365 to determine daily rate. On daily basis, the balance of the account is multiplied by this rate, and at the completion of the cycle the total interest is billed to the account. The result of this method is mathematically the same over one year as the average daily balance method, since the interest is compounded monthly, although calculated on daily balances

Some Common Terms and Characteristics in Credit Card Interest

Cash rate

Nearly all banks charge a separate, higher interest rate, and a cash advance fee (Which ranges from 1 to 5% of the amount of cash taken) on cash or cash-like transactions (called “quasi-cash” by many banks). These transactions are typically the ones for which the bank gets no transaction fee from the payee, such as cash from a bank or ATM, casino chips, and some payments to the government (and any transaction that appears in the bank’s judgment like a cash swap, such as a payment on multiple invoices). In effect, the interest rate applied on purchases is subsidized by other profits to the bank.

Default rate

Most US banks between 2000 and 2009 had a contractual default rate (ranging from 10% to 36% back in 2005), which is on average much higher than the usual APR. The rate was charged automatically if any of the listed situation occurred:  one or two behind the schedule payments, any amount in arrears beyond the due date or one more cycle, any returned payment (such as an NSF check), any charging over the credit limit (sometimes including the bank’s own fees), and – in some situations – lowering of credit rating or default with another lender, at the discretion of the bank. Under this rule, the cardholder is agreeing to pay the default rate on the due amount unless all the listed events can be guaranteed not to come about. A single delayed payment or even a non-reconciled error on any account, could result in charges of hundreds or thousands of dollars over the duration of the loan. These high effective fees offers a great reason for cardholders to keep a close eye on  all of their credit card and checking account balances (from which credit card payments are made) and for maintaining  ample margins (extra money or money available).

Variable rate

In most cases, credit card issuers charge a rate that mainly depends upon an economic indicator (prime lending rate) published by a widely accepted journal. For instance, nearly all banks in the U.S. charge interest on credit cards based upon the lowest U.S. Prime Rate as published in the Wall Street Journal on the prior business day to the start of the calendar month.

For instance, consider a rate given as 7.99% plus the prime rate will be 11.99% when the prime rate is 4.00%. These rates generally also have contractual minimums and maximums to shield the consumer (or the bank, as it may be) from high amount of the volatility in the prime rate. While these accounts are harder to account for, they can in theory be a slightly less expensive since the bank does not have to stay exposed o the risk of fluctuation of the market (since the prime rate follows inflation rates, which affect the profitability of loans).

Grace period

Many banks offer an exception to their standard method of calculating interest, in which no interest is charged on an ending statement balance that is payable by the due date. Banks have a range of rules. In some cases, the amount due must be cleared off for two months in a row to get the discount. If the required amount is not paid, then the standard interest rate calculation method is still employed. This makes it possible for cardholders to use credit cards for the ease of the payment method (to have one invoice payable with one check every month as opposed to many separate cash or check transactions), which allows them to keep money invested at a return until it must be moved to pay the balance, and lets them to keep the float on the money borrowed during each month. The bank, in fact, is marketing the convenience of the payment method (to obtain fees and possible new lending income, when the cardholder does not pay), as well as the loans themselves.

Promotional interest rates

Many banks charge very low interest, often 0%, for a predetermined number of statement cycles on certain sub-balances which ranges from the total balance to purchases or balance transfers (used to pay off other accounts), or only for purchasing specific merchandise in stores owned or contracted with by the lender. This “zero interest” credit cards allow retailers to generate more sales as such credit card schemes incentivize consumers to make more purchases on credit.