Interest Rates

Many people choose a credit card based on its advertised interest rate. (This rate is usually referred to as the annual percentage rate or “APR.”) But the advertised rate is by no means everything you need to know to avoid an unpleasant surprise later.

Actually, a credit card can come with several different interest rates. Before you apply for a card, you’ll want to learn the rates it charges for:

• purchases;
• cash advances; and
• balance transfers.

These rates can be dramatically different. And the differences may affect a card’s appeal.

For instance, if you have a steady income but are carrying a lot of credit card debt from a time when you didn’t, you may want to transfer older balances from high-interest-rate cards to a lower one. In that case, you’ll want a card with a low rate for balance transfers…but you can live with a high rate for cash advances (since you shouldn’t need them).

You’ll also need to read the fine print to determine whether the advertised APR for balance transfers—or for purchases—will remain fixed.

Some credit card companies offer a low introductory APR to attract new customers and even get them to transfer the balance from another card, but the low rate is only good for a short time.

If the transfer rate is temporary (an introductory or promotional rate, in industry jargon), you may still be interested…because you’ll pay off the balance before the end of the promotional period.

If you do pay off the balance within that period, congratulations. You’re in the minority. According to Bill Free-American Credit Counselors, 53 percent of Americans still have most their balance left on the card at the end of the promotional period.

Some cards have a steady interest rate, while others—and their numbers are growing—have rates that fluctuate dramatically. The three common kinds of APRs for credit cards are:

• fixed;
• variable; and
• tiered.

A fixed interest rate will remain the same for as long as you have the card—unless the credit card company notifies you of an interest-rate change.

You’ll also want to read the fine print regarding actions on your part that can affect the interest rate. Some card issuers will raise your rate if you make late payments. If the card you’re considering has a “penalty rate,” the credit card issuer must mention it in the solicitation materials.

A variable interest rate will change over time. It typically is based on an index, such as:

• the prime rate;
• the 1-, 3- or 6-month Treasury Bill rate;
• the federal funds rate; or
• the Federal Reserve discount rate.

  You can find these indexes listed on-line or in the money or business section of your local newspaper. When the index on which your card is based changes, so will the interest rate you have to pay.

If you have a credit card with a variable interest rate tied to the prime rate, and you start hearing that interest rates for home loans are rising, you can expect the interest rate on your card to go up, too.

But how the index is used is actually more important than which index your credit card company chooses. When comparing cards with a variable interest rate, you will want to know how that rate is computed. The three most common ways are:

• Index + Margin = Rate
• Index x Multiple = Rate
• (Index + Margin) x Multiple = Rate

These formulas can make a big difference in how much interest you pay.

The credit card issuer will choose the multiple, which can be any number. It will also choose the margin, which is expressed as a number of percentage points. So, the interest rate on a particular card could be the prime rate (index) plus 2 percent (margin).

If you are considering a variable-rate card, you’ll also want to learn whether there are caps on how high or low the interest rate can go. There usually are; the closer the high and low cap, the better.

The third common APR arrangement is a tiered rate. In this case, the outstanding balance on the card is charged at different rates for different levels. For example, the company might charge 16 percent interest on a balance of $1 to $500, and 17 percent interest on balances above $500.

Another example: A card that’s tied to a zero-percent-interest offer at certain retail locations. A variety of retail establishments offer special promotions where you can buy a new TV or a mattress or a wide variety of other products and pay no interest for several months. Typically, you have to open a new credit card account (sometimes a Visa or MasterCard with the retail establishment’s logo on the face) to get this special interest rate.

You should read the fine print carefully before you apply for one of these tiered cards (something you may not be able to do comfortably when you’re standing in line at the checkout counter, where these cards are normally “sold”).

While zero-percent interest is enticing, don’t make the mistake of thinking anything you buy with the card will be interest-free. If you run a balance on any additional charges, they’ll be computed at the card’s normal APR, which can be pretty high.

Also, you should learn how your payment will be allocated to the zero-percent-interest balance versus the higher-interest balance.

You might expect your payments to be allocated to the higher-interest balance first; but this typically is not the case. Often, your payments are applied to the zero-interest balance until it is paid off in full, while the interest multiplies fast on any other purchases, transfers or cash advances you make.

If the card uses this tactic, make sure you don’t use it for casual purchases.

As we’ve mentioned before, a zero-interest promotion usually has a limited life-span. If you don’t pay off the promotional balance in time, you can get stuck paying all the interest you would have owed at the card’s normal rate.

Next: Periodic Rate