How Credit Card Interest Works

Credit cards are essential for many Canadians. However, if you’re not responsible with your spending, you could easily go into debt.

Credit cards act like an interest free loan which is great, but once your bill arrives, you need to pay it on time and in full or you could end up paying 20%+ interest.

In this article, I’m going to break down how credit card interest works so you can better understand what types of interest you may incur, and how to best avoid them. Here’s what you need to know about credit card interest.

Types of credit card interest

As you likely already know, credit card interest isn’t just one number based on one factor. There are several components to credit card interest and several types of credit card interest. It all depends on the type of credit card you have, your payment history, and the types of purchases you make.

All credit card interest rates are calculated on an annual basis. This is why when you apply for a credit card you will see the interest rate called APR which stands for annual percentage rate. However, don’t let the word annual fool you. You aren’t charged interested only once a year. That annual interest rate is broken down and then charged monthly on cardholders with an outstanding balance.

However, APR isn’t necessarily one percentage. Different credit cards have different APRs depending on how you are using your credit card. To be clear, credit card interest used a different formula compared to compound interest.

What is the purchase interest rate?

Purchase interest rate is the most common type of interest. It’s the interest you will pay on the sum of your total purchases made with your credit card should you not pay off your statement within the grace period. 

Most credit cards have a purchase APR of 19.99%, however, some do have lower rates. I’ll discuss low interest credit cards later in this article. There are also credit cards that can charge 30% interest which are known as charge cards.

What is the cash advance interest rate?

Most people use their credit cards to make purchases, but you can also use your credit card to take out cash from an ATM as well with the cash advance option. Keep in mind that this should only be done in emergency situations. Cash advances on credit cards come with steep interest rates that are often higher than your purchase APR.

Please note that some other transactions may be considered cash advance as well. These include wire transfers, money orders, and occasionally even lottery tickets.

It’s also worth mentioning that some credit cards allow you to withdraw money at no extra cost if you have a positive balance on your card. For example, let’s say you overpaid your bills and your account has a $500 positive balance, you could withdraw that without paying the cash advance rate.

What is the balance transfer rate?

Another interest rate offered on credit cards is the balance transfer rate. A balance transfer rate is often a low promotional interest rate used to entice those in credit card debt to open a new card. With this low balance transfer rate, those who are struggling with credit card debt can get ahead with their payments and pay off their debt faster.

However, as I said above, balance transfer rates tend to be promotional and only valid for a few months. The rate then jumps up to the credit card’s standard purchase APR. This is still a useful strategy for people looking to reduce their debt.

Take a look at this article to learn about my top picks for the best balance transfer credit cards in Canada.

What is the interest free grace period?

You might have noticed above when I was discussing purchase APR that I mentioned a ‘grace period’. So, what exactly is that?

The grace period is a period of time in which you will not be charged interest. The minimum grace period for credit cards in Canada is 21 days. However, if you don’t make your payment by the time your grace period is over, you will be charged interest on the owing balance. The grace period will still apply to new purchases even if you haven’t paid off your previous credit card debt. 

Variable interest credit cards vs. fixed interest credit cards

Another thing to take into consideration is fixed rate credit cards versus variable rate credit cards. The majority of credit cards in Canada are fixed rate credit cards. So, for example, the purchase rate APR will always be 19.99%.

However, there are a couple of variable interest credit cards on the market. These types of credit cards use Canada’s prime rate plus your personal rate depending on your credit assessment. The interest rate will fluctuate when the Bank of Canada raises or lowers the prime rate which could potentially be both good or bad.

If you do decide to go with a variable interest credit card, you’ll want to shop around to ensure that you get the best rate. The prime rate is only part of the equation. The second part of this interest equation is determined based on your credit score, income, employment history, credit score, etc. Basically, the better you look on paper, the lower rate you will be given.

What is the minimum payment?

When you get your credit card statement each month you will see a list of all your purchases, the total sum of what you need to pay off, and a minimum payment amount. The minimum payment is the smallest amount you can pay off without negatively impacting your credit score and incurring a penalty interest rate. However, this does not mean you are excluded from paying interest. Interest will still be charged on any amount owing after the grace period, whether you made the minimum payment or not.

To stay in good standing, you have to, at the very least, pay off the minimum payment. Again though, it’s best to pay off the entire owing balance every month to avoid being charged interest.

How do penalty interest rates work?

If you don’t make your minimum payments each month you can incur an additional interest known as penalty interest. Penalty interest rates depend on the credit card (you’ll have to read the fine print for your specific credit card) but can be as high as 30%. Normally, you won’t be punished if you miss just one payment, but if you miss two payments in a row or a couple over time, you can expect your credit card provider to penalize you. Your credit score could also take a huge hit.

Note that penalty interest isn’t an additional interest you need to pay, but rather your normal interest rate raised to a higher level. If you do incur the penalty interest rate you will have to be diligent with making timely payments for a few months before it’s lowered again. 

Choosing a low interest credit card

If credit card interest is a concern, then consider applying for a credit card with a low interest rate. There are a number of options for low interest credit cards available to Canadians and they can be a great option for individuals who need to make a large purchase but don’t have the cash on hand. The low interest will make it easier for you to pay off that debt faster.

To help you choose, I’ve put together this list of the best low interest credit cards in Canada.

Keep in mind, low interest credit cards don’t have the same perks and rewards systems as your day-to-day credit cards. So, if you are confident that you can pay off your credit card statements each month then you should consider a travel rewards credit card or a cash back credit card to get the extra benefits.

If a low interest card makes sense for you, here’s one that I recommend.

BMO Preferred Rate Mastercard®*

The BMO Preferred Rate Mastercard®* has an annual fee of $20 is waived for the first year. The balance transfer option gives you a 3.99% introductory interest rate on balance transfers for 9 months which is a great way to reduce your debt, but note there is a 1% transfer fee. Once the promotional period is up, you’ll pay 12.99% interest which is still a great rate.

Final thoughts

Credit card interest can be a bit confusing given that there are so many types of interest involved. It’s important to be aware of different rates and charges that can apply with credit cards but the main takeaway is your best bet is to use your credit card responsibly and pay it off in full every month.