ABCs of Credit Card Interest

Whether you've been charging for years, or you've just received your first credit card, you're due for a lesson in the basics of interest.

In the great words of the Jackson 5, ABCs are as easy as counting to three. While Michael and the gang weren't singing about credit cards, we'll stick with their cue by making this essential lesson in credit card interest easy as can be.

Rule One: Rates can change

The interest on credit card accounts is usually variable, meaning that it can go up or down over time. Typically, the rate you pay is the sum of two components: a variable benchmark rate and a margin. A common benchmark rate is the prime lending rate, while the margin is a fixed value that's determined by your credit qualifications.

Say, for example, that you opened a credit card account in June of 2007, and the rate was defined in your account documentation as prime plus 5 percent. Since the prime rate was 8.25 percent at that time, you were charged 13.25 percent. Now, fast forward one year. The prime rate has dropped to 5 percent and your interest rate has reflected these changes, decreasing to 10 percent.

On the flip side, rates can go up, too. Between February and December of 2005, the prime rate moved from 5.5 percent to 7.25 percent. Had you held this account during that time period, your rate would again reflect the change, increasing by 1.75 percentage points. Fortunately, your rate can't go up indefinitely. Your account documentation should specify a maximum rate that can't be exceeded, no matter what happens to the benchmark rate.

Rule Two: Interest isn't cheap

Debt can be characterized as either secured or unsecured. The former gives the lender the right to seize specific property (a home or car, for example) if you don't pay the bills as agreed. Unsecured creditors don't have this right; if you don't pay, they can only send you to collection agencies and mar your credit report.

Credit card debt is unsecured. Because card issuers accept more risk by lending without security, they charge more for their services. That's why credit card interest rates are higher than rates charged on auto loans and mortgages.

Rule Three: Interest isn't tax deductible

You can deduct mortgage interest on your taxes, but you can't deduct interest paid on your credit card accounts. This factor is relevant when you're evaluating different options to satisfy specific funding needs. Say, for example, that you need to raise $25,000 to pay for your daughter's wedding. You may have enough credit available to charge the wedding expenses on your plastic. But a review of the rates and tax advantages may indicate that home equity debt in the form of a home equity loan or a mortgage refinance, would be considerably cheaper. (Just don't forget the closing costs and the risks associated with using your home as security.)