Understanding Interest & Fees

Credit cards can be complicated things. Not only do you have to contend with the complexities of rewards programs, but you'll also have to figure out what all of those quickly spoken, small-text words and abbreviations mean. APR? Late fees? Cash advance? What do they all mean?

Companies have been using these terms for decades, and you can navigate the word soup quickly as long as you know the basics. Unfortunately, most of us are not taught these basics when in school, leaving many of us mired in a pile of debt that we don't understand.

Instead of waiting until you're sitting in a debt counseling office, let's walk through the basics now. We'll focus on the two things that tend to get consumers into the most trouble: interest and fees.

What Is Interest?
If you're just going for the dictionary definition, "interest" is "money regularly paid at a particular rate for the use of money lent, or for delaying the repayment of debt."

Interest rates matter, but they are not always the main consideration. If you pay on time, a high rate doesn't matter too much. What does matter is what happens in the second part of that definition: "for delaying the repayment of debt."

Here's how it works:

You use your credit card to go shopping, perhaps purchasing a new TV. As you did not pay with your money, you essentially asked the credit card company to lend you the money, with a promise to pay it back.

The company charges the store a small percentage of the sale (2%, perhaps). This charge is the processing fee. If you go to a store that only accepts cash, it's because they probably have low-profit margins and can't absorb that cost very easily.

At the end of the billing cycle, the company asks for its money back. They already made a few bucks from your TV purchase, but still, they want their money back.

This is where things start to get...interesting (see what we did there?). Let's walk through two possible scenarios.

Scenario 1: You pay your bill.

In this scenario, you pony up the cash you borrowed to buy your TV. The company gets its loan money repaid, it's made a small profit off the deal, and you have your new television. Everyone's happy.

Scenario 2: You don't pay your bill (or you only pay a part of it).

Let's say you don't pay your bill at all, and the period you have to pay it (usually around 20-30 days after you get the bill) elapses. Now the company is tired of not getting its money back, so it starts charging interest on the loan, at whatever rate the agreement prescribed. If that TV was $500, and the rate (known as the Annual Percentage Rate or APR) on your card is 15%, one day after your grace period is over, you'll owe about $500.20 on your TV.

Annual Percentage Rate (APR) Explained
The Annual Percentage Rate, or APR, is the amount you pay if you fail to make on-time payments. This amount is only applied if you miss a payment, or any balances carried over from one billing cycle to the next after the grace period is over.

However, you're not paying a flat 15% on everything. The APR is assessed on a daily basis. Companies will take your current APR, and divide it by 365, giving them the daily percentage rate that will add up to the 15% annual rate. If your APR is 15%, that means you'll be assessed about .04% daily on your leftover balance. At the end of the month, your $500 TV will cost you about $506.

You will keep seeing that balance rise. The trap many people get into is paying only the minimums. Minimum payments pay off the interest first and then cover a small part of the principal, which is the amount you paid for the TV. If you only make minimum payments, you'll be spending years paying off your balance and end up paying thousands of dollars for a TV that only cost $500.

This is how the system works. You pay for an item for which you don't have the money up front. The company makes a small profit. If you pay them back on time, you don't pay anything else. If you don't pay on time, the company charges interest on what you owe, and they make more money. If you only pay minimums, you'll be stuck paying for that television for well over a decade, and it's going to cost you.

Variable vs. Fixed APR and Prime Rate
While we're on the subject, it's important to note the difference between variable APR and fixed APR, and what Prime Rate is.

Fixed APR cards keep the same rate throughout their lifetime (unless stated otherwise). In general, you'll see the same rate applied at all times.

Variable APR allows the company to change your rate anytime, as long as they provide a 15-day notice. The APR typically varies based on the Prime Rate. The Prime Rate is the market rate for loans, which determines the lowest rate possible for a loan. Most companies will add the Prime Rate amount to your interest rate, which gives them the total amount you're paying. So in reality, that 15% APR may be 18.5% if the Prime Rate is at 3.5%. There is usually a variable rate maximum of around 29.9%, which is the variable rate with the prime rate added.

Is Interest Applied Anywhere Else?
Yes, it does! You also pay interest on your cash advances, which is just a fancy way of saying "pulling money from the ATM with your card." However, unlike the regular purchase APR, which only applies if you fail to pay back the amount on time, the interest applies immediately. Furthermore, credit card companies usually have a lower base APR for cash advances than for purchases, so that $40 ATM withdrawal will be far more than $40 if you carry a balance at the end of the billing cycle.

If you are transferring a balance from one card to another, you'll also be assigned an interest rate. The APR for transfers is often the same as the APR for purchases, and the interest won't be applied until the after the billing cycle grace period.