Tax policy can affect people's decisions in many ways. A classic example is Amsterdam's tall, narrow row houses. Legend has it they were built that way because properties were taxed based on their width at the time of construction (there were other reasons, too).
You may have heard interest is tax-deductible. If so, it's time to learn more about tax policy before you let your credit card interest build up like those iconic Dutch houses.
No, you cannot deduct credit card interest charges from your personal taxes. Decades ago, the IRS offered a personal interest tax deduction, but that changed when Congress passed the Tax Reform Act of 1986, which eliminated this popular deduction.
Congress reasoned that allowing consumers to deduct their credit card interest payments encouraged spending and credit card debt. Therefore, Congress hoped that by removing this deduction, consumers would dedicate more income to savings. That way, consumers would be making money from interest instead of paying it.
In contrast, you can still deduct interest payments on home loans, and money borrowed to purchase investment properties. This is possible when you choose to claim any itemized deductions on your federal income tax return. You can also deduct student loan interest even if you don’t itemize deductions and deduct interest on business purchases from your business tax liability.
So, how does credit card interest work? Your credit card offers you a line of credit, and when you utilize that line, it becomes a loan. And like any loan, the lender will impose interest charges based on the amount loaned and the time you take to pay back the loan.
But beyond those basics, credit card interest rates work differently than most other loans. You agree on an interest rate before borrowing any money with most loans, but that's not the case with many credit card accounts. Instead, many cards are advertised with a range of interest rates. For example, a credit card can offer a rate of between 12.99% and 22.99% APR, or it can say that the rate is either 14.99%, 17.99%, or 19.99% APR.
With credit cards, the rate is based on your creditworthiness when you apply for the card. You won't know the rate until your application has been approved and your account has been opened. So, if you’re wondering how to lower your credit card interest rate, try to remain in good standing and pay each statement on time.
Furthermore, most credit cards have variable rates that will rise and fall with the Prime Rate. Since the Prime Rate is based on the federal funds rate, every time the Federal Reserve's Board of Governors changes that rate, the rate changes for most of the credit cards in the United States.
The amount of interest you're charged is based on your account's average daily balance. So first, you calculate the average daily balance by adding up your balance at the end of each day of your statement period. Then, divide that amount by the number of days in your statement period.
You then take your account's Annual Percentage Rate (APR) and divide it by 365 (the number of days in a year) to figure a daily percentage rate. That daily percentage rate is applied to the account's average daily balance and is compounded. That means that interest is added to the first day's balance before determining the second day's balance, and so on.
Fortunately, nearly all credit cards allow you to avoid interest charges when you pay your entire statement balance before the due date. Technically, interest is still accruing, but it's waived when you pay off your statement balance in full each month.
You can also avoid interest charges temporarily by opening a card with a 0% APR introductory financing offer for new purchases. By law, these offers must last at least six months. When the promotional financing rate ends, you'll owe interest on any remaining balance at the standard interest rate.
Many credit cards also have a penalty interest rate. This is a much higher rate imposed when the cardholder fails to make a payment, makes a late payment, or has a payment returned. Credit cards can also charge different interest rates for balance transfer and cash advances.
As with credit card interest charges, personal credit card fees are not deductible from your income taxes. But if you have a small business, you may deduct your business credit card fees from your business taxes. These fees can include annual fees, late fees, and fees for additional authorized employee cardholders. As with other business expenses, business credit card fees can be considered a tax deduction, but you should always consult your accountant or tax professional.
Although credit card interest isn't deductible from your personal income taxes, there are some kinds of interest payments that are. For example, the IRS allows you to deduct your interest payments for your home mortgage and student loans.
Let's say that you earned $50,000 in taxable income last year, but you paid $6,000 in interest charges on your primary residence and $4,000 on your student loans. In this case, you'd only owe taxes on $40,000 because you were able to deduct these specific interest charges from your taxable income. Due to the personal interest tax deduction, you have no tax liability on the $10,000 in interest paid that year on your home loan and student loans.
A deductible interest payment is any interest charge that the IRS says you don't have to pay taxes on. Currently, the two largest categories of deductible interest payments are mortgage interest on your primary residence and student loan interest.
And there are limits to even these deductions. For example, the home mortgage interest deduction is limited to interest paid on up to $750,000 of home mortgage debt if you file as an individual, a joint filer, or head of household. On the other hand, married taxpayers who file separately can deduct interest paid on up to $375,000 of mortgage debt each. And student loan interest is fully deductible, but only if your modified adjusted gross income (MAGI) is less than $70,000 per year or $140,000 if filing jointly. After those amounts, your deduction gradually phases out. Once your MAGI reaches $85,000 ($170,000 if married filing jointly), you can’t deduct student loan interest at all.
If you are a small business owner, you can deduct many of your interest charges that aren't deductible on your personal tax returns.
Let's say that you're a contractor purchasing supplies for a job, and you have to charge the purchases to your credit card. It may take several months to complete the project and get paid, by which time you've incurred significant interest charges. Since these charges were a business expense, the IRS will allow you to deduct the amount paid from your profit, and you won't have to pay taxes on it.
You may also be able to deduct the interest charges for other business expenses such as purchasing inventory, supplies, travel, and services. But, again, just consult your accountant or tax professional to ensure that you're complying with the tax code.
While you can't deduct credit card interest or fees from your personal taxes, you can with some other types of interest payments. At the same time, credit card interest payments and fees are often deductible from your business taxes. By understanding how the IRS treats credit card interest and fees, you can make the right financial decisions to minimize your tax burden.
Luckily, with Self, you can also rebuild or even establish credit with the help of our credit builder card. Get started with one of our credit building programs today!
Intuit Turbotax. “Is Interest on Credit Cards Tax Deductible?” https://turbotax.intuit.com/tax-tips/small-business-taxes/is-interest-on-credit-cards-tax-deductible/L3TlLAaoI. Accessed September 30, 2021
Bankrate. “Prime rate, federal funds rate, COFI” https://www.bankrate.com/rates/interest-rates/prime-rate.aspx. Accessed September 30, 2021
Chase. “What is the daily periodic rate & how do you calculate it?” https://www.chase.com/personal/credit-cards/education/interest-apr/calculate-daily-periodic-rate. Accessed Sep 30, 2021
IRS. “Topic No. 505 Interest Expense” https://www.irs.gov/taxtopics/tc505. Accessed Sep 30, 2021
IRS. “Publication 936 (2020), Home Mortgage Interest Deduction” https://www.irs.gov/publications/p936. Accessed Sep 30, 2021
IRS. “Topic No. 456 Student Loan Interest Deduction” https://www.irs.gov/taxtopics/tc456. Accessed Sep 30, 2021
The Balance. “Student Loan Interest Deduction Phase-Outs” https://www.thebalance.com/student-loan-interest-deduction-3193022#student-loan-interest-deduction-phase-outs. Accessed September 30, 2021
Jason Steele has been writing about credit cards and personal finance since 2008, poring through the terms and conditions of credit card agreements to understand the minutiae of how these products work. His work has appeared on Yahoo, MSN, HuffingtonPost and other major news outlets. In his free time, Jason’s a commercial pilot. He graduated from the University of Delaware with a degree in History. See Jason on Linkedin and Twitter.
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