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While it's true that your credit score plays an important factor in determining your interest rate on any new line of credit, there are a few reasons why that rate is notoriously high on credit cards — and it has nothing to do with your creditworthiness.
Most credit card issuers offer a variable annual percentage rate (APR), which means that the interest rates fluctuate with market conditions. They are often set by looking at the Federal Reserve's benchmark prime rate, plus adding on a specific number of percentage points depending on the borrower's credit. For example, the current prime rate is 3.25%. Meanwhile, the Chase Freedom® offers a variable APR ranging from 14.99% to 23.74%. Your interest rate will be somewhere in this range, but can also go up or down over the course of having the card.
But even though the Fed decreasing the prime rate means your credit card APR will likely also decrease, there are a few reasons why it still exceeds interest rates on other loans.
Below, CNBC Select breaks down three reasons why your credit card interest rate is so high and what you can do to avoid ever having to worry about it.
Besides the segment of secured credit cards that allows beginners to have a credit line equal to a security deposit they pay upfront, the majority of credit cards are unsecured loans.
Unlike a mortgage or a car loan where the bank has collateral to take if the borrower doesn't make their loan payments, there is nothing the bank or card issuer can collect from you if you're late on a bill — besides interest. With a credit card, borrowers are given a loan without any security that they will pay it back.
"The lack of a physical asset acting as security means more risk for the issuer," financial expert John Ulzheimer, formerly of FICO and Equifax, tells CNBC Select. "They can't repo your dinner or your nice vacation that you paid for with your credit card. They take a default as a loss if they can't collect from you."
This added risk translates into a higher interest rate to cardholders since it helps banks to subsidize the risk of issuing unsecured credit to millions of people.
Federal student loans, which are backed by government funds if a borrower defaults, also carry less risk than credit cards and thus have lower interest rates. The average 15.78% credit card APR, according to the Federal Reserve's most recent data, is more than five times higher than the 2.75% federal student loan interest rate for undergraduates for the 2020-21 school year. Even the federal rates for unsubsidized graduate student loans (4.30%) and parent loans (5.30%) don't come close to credit card interest rates.
When a borrower takes out a personal loan, a bank often knows what it is for, whether it's to finance a first home or a new car, and when it will be paid back. For example, a bank can issue someone a $25,000 car loan with terms to pay it over 48 monthly installments.
But when a borrower opens up a credit card, the card issuer doesn't know where the money will be spent, how often it will be used, how much will be used (within the provided credit limit) or when it will be paid back. In this case, the credit card company charges high interest rates to protect themselves if the cardholder racks up a bunch of debt and never pays it off.
Issuers never know what the balances will be and thus can't predict how much they will have in their banks, so, given this uncertainty, the high interest rate acts as a way for the card company to still make consistent money — which leads us to our last reasoning.
Since credit cards are designed for large-scale consumption, issuers do business with all sorts of consumers. Because it's risky to lend credit to millions of Americans with varying credit histories, issuers charge higher average APRs across their entire customer base.
But keep in mind, you have some say in how much you pay interest: "Interest on a credit card is optional," Ulzheimer says. If you pay off your balance each month, you don't have to worry about being charged.It's therefore important to spend within your means and pay your balance off in full. We go over more tips to avoid interest below.
Credit cards may be notoriously known for their high interest rates, but the good news is that you don't have to pay them if you never carry a balance. This is just one of a few ways you can avoid ever having to pay the high interest rates that credit cards charge.
We round up three tips below:
- Pay off your balance in full each month: High interest rates only hurt you if you carry a balance. Make sure you make your monthly bill payments in full so you never accrue interest, and if you have trouble remembering to pay on time, automate your bills to help.
- Find a low-interest credit card: If you think you may end up carrying a balance at some point, consider a credit card with low interest. It's not ideal to have a balance, but going with a low-interest card can at least save you some money. Some of the best low interest credit cards we found include the Capital One VentureOne Rewards Credit Card and the U.S. Bank Visa® Platinum Card. If you already carry a large balance and are paying high interest, look into transferring your debt to a balance transfer credit card. Many balance transfer cards, like the Citi Simplicity® Card, require good to excellent credit to qualify, but a few like the Citi® Double Cash Card (see rates and fees) allow applicants with fair credit to qualify.
- Request a lower APR: You can try calling your card issuer and negotiating a lower interest rate. Keep in mind that before doing so you'll want to make sure you have good credit and a healthy payment record to show for it.
Information about the Capital One VentureOne Rewards Credit Card, Citi Simplicity® Card has been collected independently by CNBC and has not been reviewed or provided by the issuer prior to publication.