Everything You Need to Know About Credit Card Interest

With over 76 million credit cards in circulation in Canada, they are very popular financial products, and there is a card for everyone: with no annual fee, a reduced interest rate or cash back, for instance. Additionally, they can serve different purposes, so choose your credit card wisely: to build your credit, to earn rewards, to take advantage of low interest rates or special offers, etc. Often misunderstood, credit card interest rates could play tricks on you if you’re not careful.

When do you have to pay interest?

To avoid paying interest on purchases, you must pay the entire balance shown on your statement before the end of the grace period. This grace period corresponds to an interest-free period of about 21 days after your monthly statement has been issued. If you are unable to pay your balance in full, you will have to pay interest.

In this case, interest generally applies retroactively from the date of purchase. Even if you paid part of your balance, you will have to pay interest on the total amount of purchases! For example, let’s say you buy a computer for $2,000 on June 25. In July, you receive your account statement. Not having the funds to pay the balance, you simply pay $100 to cover the minimum payment required. On your next statement, interest will apply from June 25, on $2,000 (not $1,900).

For cash advances and balance transfers, there is no grace period. In addition, their interest rates are often higher compared to purchases. For example, if you make a withdrawal from your credit card at the ATM, the interest charges start right away.

Some credit cards offer a variable interest rate that changes according to the prime rate of the issuing bank, to which a certain percentage is added, for example “prime rate + 4%”. If the prime rate goes up, your interest rate goes up as well.

What if you don’t pay your balance in full and make new purchases?

Generally, if you don’t pay your balance in full once, interest only applies to the related purchases. In the previous example, you will pay interest on your computer, but not on your new purchases. Know that you are not alone, because only 71% of Canadians pay off their entire credit card balance each month!

However, from the second statement not paid in full, you lose this privilege. With two missed payments or more, interest applies from the first day, meaning you no longer have a grace period even for new purchases. To use the computer example again, if for a second time, you only pay $100 on your balance, you will lose your grace period and will have to pay interest on this amount as well as on all the new purchases you will make.

Interest calculation

The interest rate you see on your statement is an annual rate. When interest is applied to your account, the financial institution will calculate the interest based on the daily rate. Take your annual interest rate and divide it by 365. This daily rate will then be multiplied by the cost of your purchases and added to your account statement.

For example, let’s say you make purchases that bring your account balance to $2,000 with your credit card, which has an annual interest rate of 19.99%. Your card was at $0, so your account balance is now $2,000. When you receive your monthly statement, you have a grace period of 21 days to make the payment. Let’s see what happens if you don’t have the money in your account by the due date.

To find out how much interest you’ll have to pay, let’s first calculate the daily interest rate for your credit card. The annual interest rate (19.99%) divided by 365 days becomes a daily rate of 0.055%. Let’s assume that your purchases were made 61 days ago, so we multiply this rate by 61 days, then by the amount of the purchases. You should pay $66.82 in interest.

See the table below for additional examples illustrating interest charges for a 30-day period based on different rates.

If there are multiple purchases made on different dates, the calculation may be more complicated, as explained in the following image from the BMO Cash Back World Elite Cardmember Agreement.

Also, if you can only pay an amount of $1,000 of the total due on the next statement, the bank will first use this amount to reimburse interest charges and other fees, before applying it to the card balance.

Choose the right card

If you pay off your credit card in full every month, get a credit card that maximizes rewards or cash back. Otherwise, aim to get the card with the lowest interest rate possible. Be aware, however, that the best interest rates on the market are offered to people with excellent credit, as they are considered low risk in terms of paying off their card.

The best way to determine what rates you might qualify for is to know your credit score and look at the range of rates offered for cards that require that score. To do this, you can use a credit card comparison tool and enter your score. It will find the best offers based on this information.

Paying off credit cards or investing?

You may have heard people say that it is better to invest your money than to pay your debts. This advice does not apply to credit card debt.

It’s true that it is better to invest your money if the projected return exceeds the interest rate on your debts (such as a 6% return in a registered account versus paying a debt at 4%). In other words, if you are almost certain that the return on your investments is greater than the interest on your debt, invest.

However, this is never (or almost never) the case for a credit card. None of very few investments will bring you a return of 19.99% (or even 12% for cards with low interest rates)! Always prioritize paying off your credit card.