How credit card interest works: eight things you need to know

Australians are paying interest on a staggering $21.4 billion in credit card debt, yet many cardholders don't fully understand the simple rule that determines whether interest applies at all. And getting it wrong can turn an everyday purchase into a surprisingly expensive debt.

Australians love a credit card. In fact, there are 14.9 million of them currently in circulation, according to the latest Reserve Bank figures.

While credit cards can be a convenient payment and budgeting tool, they can also be an expensive form of borrowing when fees and interest come into play.

As a whole, Australian cardholders were paying interest on $21.4 billion worth of credit and charge card debt in July, Reserve Bank data shows.

Despite the prevalence of credit card debt, many cardholders will be in the dark about exactly how interest is calculated, when it applies and what they can do to avoid it.

So, whether you're considering applying for a card for the first time, or you already have one in your wallet, here's what you need to know about how credit card interest works.

1. What is the average credit card interest rate?

There's a real spectrum of credit card interest rates.

The average credit card rate was sitting at 18.67% p.a. in July, according to an analysis of Reserve Bank data by financial comparison website money.com.au.

The reality is that interest rates vary depending on the type of credit card in question though.

Low rate cards, for instance, typically come with interest rates in the 10% p.a. to 15% p.a. range, while premium and rewards cards generally have rates in the 19% p.a. to 24% p.a. range.

2. Why do credit cards have more than one interest rate?

When most people think about the interest rate on a credit card, they'll be thinking about the purchase rate: the rate for everyday purchases made on the card.

But it's unlikely to be the only rate attached to a card. Cash advances, for one, generally have a separate interest rate that is higher than the purchase rate.

Special rates also apply to balances transfers (debt moved from an existing card to a new card).

Balance transfers usually come with no or very-low introductory rates for a set period (e.g. 12 months), before reverting to the card's purchase or cash advance rate.

3. How is credit card interest actually calculated?

The way that credit card interest is calculated differs between card providers. Many calculate it daily.

To do this, the annual purchase rate (divided by 365) will be applied to the outstanding balance at the end of each day, then those daily interest charges will be tallied across the statement period.

As a simple example, let's say you made a $750 purchase on the first day of a 30-day statement period on a credit that has a purchase rate of 13% p.a.

If your outstanding balance stayed at $750 for the entirety of the statement period, interest would be applied each day at a rate of 0.0356%.

That would work out at 27 cents in interest per day, or around $8 over the 30 days.

4. When does credit card interest kick in?

When it comes to credit card interest, one factor matters more than almost any other: whether you pay your statement balance in full by the due date.

If you don't pay off your balance, that's when interest often kicks in. But exactly when that happens depends on your card.

Credit cards run on statement periods. These are usually around 30 days during which time your card activity is compiled before a statement is issued detailing what you spent, what you owe and when it needs to be paid.

If your card offers interest-free days (more on these below), you'll generally avoid interest on purchases if you pay off the full statement balance by the due date specified on the statement.

If you don't pay that balance in full, you will lose the benefit of interest-free days. If that happens, interest will be charged on the remaining balance and may also apply straight away to any new purchases you make.

5. How do interest-free days work?

Most cards in Australia come with interest-free days: a feature which rewards cardholders who consistently clear their statement balances with more time to pay off their debt.

Interest-free periods generally range from 44 to 55 days. But that also includes the statement period. For a card with 55 interest-free days, that would equate to 25 days beyond the typical 30-day statement period.

There's an important caveat though. Most card providers specify that the interest-free period is 'up to' a specific number of days.

So, a purchase made on the first day of a statement period may be eligible for the full 55 interest-free days, but one made later in the month would be receive fewer days.

While interest-free days may be simple to keep if you pay off your balance in full each month, how can regain them once you lose them?

To get them back right away you'll need to pay off the entire card balance. To get them back from the start of the next statement period you'll need to fully pay off the previous statement balance.

6. Can you avoid interest by making the minimum repayment?

Depending on your bank or card provider, your credit card statement will outline a few different repayment options.

One is to pay off your statement balance in full. Another is to make the minimum repayment amount, which is necessary to avoid fees and keep using your card.

Your minimum payment will depend on your balance and card provider. American Express, for one, charges 2.5% of your closing balance or $30 (whichever is greater), while Westpac charges 2% of your closing balance or $10.

If you only make the minimum repayment (or anything below the full balance owing), you're likely to lose your interest-free days and you may start to accrue interest on your outstanding balance as well as new purchases going forward.

7. Which credit card purchases attract interest immediately?

While eligible everyday purchases won't attract interest straight away, there are some transactions that will.

Cash advances, for one, start accruing interest immediately because there's no interest-free period associated with them.

Cardholders may assume that this only includes cash that is withdrawn from an ATM or over the counter using a credit card, but that's not the case.

Some credit card providers have broader definitions of cash advances. CommBank, for instance, considers gambling, money transfers and travellers' cheques to be types of cash advances.

8. How to avoid paying credit card interest

The easiest way to avoid paying interest on your credit card payments is to pay off your entire balance each statement period.

It could even be worth doing away with a credit card altogether and opting for another payment option like a debit card instead.

That can be easier said than done though. For cardholders who do regularly accrue interest on their credit card debt, ASIC's Moneysmart has a few suggestions.

• Assess your budget to find areas that you can cut back to reduce your credit card spending or dedicate more money to your debt 
• Ask your card provider to lower your credit limit to reduce the temptation of spending more
• See if you can make the switch to a low rate credit card if you're regularly carrying a balance
• Look into balance transfer offers or personal loans which may be able to help you pay off existing debt at a lower rate

For further strategies on dealing with debt, check out Money's piece on what to do if your debt is getting out of control.

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