Credit card interest is a way in which credit card issuers generate revenue. A card issuer is a bank or credit union that gives a consumer (the cardholder) a card or account number that can be used with various payees to make payments and borrow money from the bank simultaneously. The bank pays the payee and then charges the cardholder interest over the time the money remains borrowed. Banks suffer losses when cardholders do not pay back the borrowed money as agreed. As a result, optimal calculation of interest based on any information they have about the cardholder's credit risk is key to a card issuer's profitability. Before determining what interest rate to offer, banks typically check national, and international (if applicable), credit bureau reports to identify the borrowing history of the card holder applicant with other banks and conduct detailed interviews and documentation of the applicant's finances.
Interest rates
Interest rates vary widely. Some credit card loans are secured by real estate, and can be as low as 6to 12% in the U.S. (2005). Typical credit cards have interest rates between 7and 36% in the U.S., depending largely upon the bank's risk evaluation methods and the borrower's credit history. Brazil has much higher interest rates, about 50% over that of most developing countries, which average about 200% (Economist, May 2006). A Brazilian bank-issued Visa or MasterCard to a new account holder can have annual interest as high as 240% even though inflation seems to have gone up per annum (Economist, May 2006). Banco do Brasil offered its new checking account holders Visa and MasterCard credit accounts for 192% annual interest, with somewhat lower interest rates reserved for people with dependable income and assets (July 2005). These high-interest accounts typically offer very low credit limits (US$40 to $400). They also often offer a grace period with no interest until the due date, which makes them more popular for use as liquidity accounts, which means that the majority of consumers use them only for convenience to make purchases within the monthly budget, and then (usually) pay them off in full each month. As of August 2016, Brazilian rates can get as high as 450% per year.
Calculation of interest rates Most U.S. credit cards are quoted in terms of nominal annual percentage rate (APR) compounded daily, or sometimes (and especially formerly) monthly, which in either case is not the same as the effective annual rate (EAR). Despite the "annual" in APR, it is not necessarily a direct reference for the interest rate paid on a stable balance over one year.
The more direct reference for the one-year rate of interest is EAR. The general conversion factor for APR to EAR is , where represents the number of compounding periods of the APR per EAR period.
For a common credit card quoted at 12.99% APR compounded daily, the one-year EAR is , or 13.87%; and if it is compounded monthly, the one-year EAR is or 13.79%. On an annual basis, the one-year EAR for compounding monthly is always less than the EAR for compounding daily. However, the relationship of the two in individual billing periods depends on the APR and the number of days in the billing period.
For example, given twelve billing periods a year, 365 days, and an APR of 12.99%, if a billing period is 28 days then the rate charged by monthly compounding is greater than that charged by daily compounding ( is greater than ). But for a billing period of 31 days, the order is reversed ( is less than ).
In general, credit cards available to middle-class cardholders that range in credit limit from $1,000 to $30,000 calculate the finance charge by methods that are exactly equal to compound interest compounded daily, although the interest is not posted to the account until the end of the billing cycle. A high U.S. APR of 29.99% carries an effective annual rate of 34.96% for daily compounding and 34.48% for monthly compounding, given a year with twelve billing periods and 365 days.
Table 1 below, given by Prosper (2005), shows data from Experian, one of the three main U.S. and UK credit bureaus (along with Equifax in the UK and TransUnion in the U.S. and internationally). (The data actually come from installment loans [closed end loans], but can also be used as a fair approximation for credit card loans [open end loans]). The table shows the loss rates from borrowers with various credit scores. To get a desired rate of return, a lender would add the desired rate to the loss rate to determine the interest rate. Though individual borrowers differ, lenders predict that, as an aggregate, borrowers will tend to exhibit the same payment behavior that others with similar credit scores have shown in the past. Banks then compete on details by making analyses of how to use data such as these along with any other data they gather from the application and history with the cardholder, to determine an interest rate that will attract borrowers by remaining competitive with other banks and still assure a profit. Debt-to-income ratio (DTI) is another important factor for determining interest rates. The bank calculates it by adding up the borrower's obligated minimum payments on loans, and dividing by the cardholder's income. If it is more than a set point (such as 20% in this example) then loans to that applicant are considered a higher risk than given by this table. These loss rates already include incomes the lenders receive from payments in collection, either from debt collection efforts after default or from selling the loans to third parties for further collection attempts, at a fraction of the amount owed.
+Table 1: Expected default loss rates for 2004 installment loans with given credit ratings and less than 20% DTI Experian score Expected annual loss rate (as % of loan balance) 760+ low risk 0.2 720-759 0.9 680-719 1.8 640-679 3.3 600-639 6.2 540-599 11.1 540 high risk 19.1 No credit rating no data (the lender is on its own) To use the chart to make a loan, determine an expected rate of return on the investment (X) and add that to the expected loss rate from the chart. The sum is an approximation of the interest rate that should be contracted with the borrower in order to achieve the expected rate of return.
Interrelated fees Banks make many other fees that interrelate with interest charges in complex ways (since they make a profit from the whole combination), including transactions fees paid by merchants and cardholders, and penalty fees, such as for borrowing over the established credit limit, or for failing to make a minimum payment on time.
Banks vary widely in the proportion of credit card account income that comes from interest (depending upon their marketing mix). In a typical UK card issuer, between 80% and 90% of cardholder generated income is derived from interest charges. A further 10% is made up from default fees.
Laws Usury
Many nations limit the amount of interest that can be charged (often called usury laws). Most countries strictly regulate the manner in which interest rates are agreed, calculated, and disclosed. Some countries (especially with Muslim influence) prohibit interest being charged at all (and other methods are used, such as an ownership interest taken by the bank in the cardholder's business profits based upon the purchase amount).
United States
Credit CARD Act of 2009
This statute covers several aspects of credit card contracts, including the following: Limits over-the-limit fees to cases where the consumer has given permission. Limits interest rate increases on past balances to cases in which the account has been over 60 days late. Limits general interest rate increases to 45 days after a written notice is given, allowing the consumer to opt out. Requires extra payments to be applied to the highest-interest rate sub-balance.
Truth in Lending Act
In the United States, there are four commonly accepted methods of charging interest, which are listed in the section below, "Methods of Charging Interest". These are detailed in RegulationZ of the Truth in Lending Act. There is a legal obligation on U.S. issuers that the method of charging interest is disclosed and is sufficiently transparent to be fair. This is typically done in the Schumer box, which lists rates and terms in writing to the cardholder applicant in a standard format. RegulationZ details four principal methods of calculating interest. For purposes of comparison between rates, the "expected rate" is the APR applied to the average daily balance for a year, or in other words, the interest charged on the actual balance left lent out by the bank at the close of each business day.
That said, there are not just four prescribed ways to charge interest, to wit those specified in RegulationZ. U.S. issuers can charge interest according to any reasonable method to which the card holder agrees. The four (or arguably six) "safe-harbour" ways to describe and charge interest are detailed in RegulationZ. If an issuer charges interest in one of these ways then there is a shorthand description of that method in RegulationZ that can be used. If a lender uses that description, and charges interest in that way, then their disclosure is deemed to be sufficiently transparent and fair. If not, then they must provide an explanation of the method used. Because of the safe-harbour definitions, U.S. lenders have tended to gravitate towards these methods of charging and describing the way interest is charged, both because it is easy and because legal compliance is guaranteed. Arguably, the approach also provides flexibility for issuers, enhancing the profile of the way in which interest is charged, and therefore increasing the scope for product differentiation on what is, after all, a key product feature.
Pre-payment penalties Clauses calling for a penalty for paying more than the contracted regular payment were once common in another type of loan, the installment loan, and they are of great concern to governments regulating credit card loans. Today, in many cases because of strict laws, most card issuers do not charge any pre-payment penalties at all (except those that come naturally from the interest calculation methodsee the section below). That means cardholders can "cancel" the loan at any time by simply paying it off, and be charged no more interest than that calculated on the time the money was borrowed.
Cancelling loans Cardholders are often surprised in situations where the bank cancels or changes the terms on their loans. Most card issuers are allowed to raise the interest rate (within legal guidelines) at any time. Usually they have to give some notice, such as 30 or 60 days, in writing. If the cardholder does not agree to the new rate or terms, then it is expected that the account will be paid off. That can be difficult for a cardholder with a large loan who expected to make payments over many years. Banks can also cancel a loan and request that all amounts be paid back immediately for any default on the contract whatsoever, which could be as simple as a late payment or even a default on a loan to another bank (the so-called "Universal default") if the contract states it. In some cases, a borrower may cancel the account within the time allowed without paying off the account. As long as the borrower makes no new charges on the account, then the borrower has not "agreed" to the new terms, and may pay off the account under the old terms.
Average daily balance