A Quick Guide to Estimating Your Credit Card’s Annual Percentage Rate
Most people pay close attention to several different things when applying for a new credit card . This could be a signup bonus or a reward they can earn. But one thing that should always be on your radar is the effective annual interest rate, or the annual interest rate shown on the map.
This post was originally published on Credit.com .
At first glance, you might think you have a good understanding of what the annual interest rate is and how it is calculated. However, this can be confusing and you can easily be left in the dark. To help you become a more empowered consumer, we’ll cover the basics: when interest is charged on accounts, how it is actually calculated, and what might affect the annual interest rate you receive.
When will interest be calculated?
A little known benefit of most credit cards is that they have a grace period. This is the time period from the closing of the credit card statement to the actual due date. The number of days depends on the card issuer, but is usually at least 21 days. With most cards, no interest will be charged if you pay the balance of your statement in full before the grace period ends. However, if you pay only a portion of your balance before the due date, then interest will begin to accrue on the purchases you make. (Remember, credit cards don’t have to offer a grace period, so be sure to read the fine print of the card you’re going to see if it offers one.)
How do you calculate interest?
If you have a credit card balance, you will likely see interest payments on your statement. But do you know how this figure was obtained?
First, it’s important to understand some terminology. We often see that the terms and conditions of the credit card mention the annual percentage rate. Although this means an annual interest rate, interest is not calculated on an annual basis. In fact, it is calculated on a daily basis, which is better known as the periodic interest rate.
So, let’s say your card has an annual interest rate of 16%. To figure out what the periodic interest rate will be, you divide 16 by 365 days (some card issuers use 360). This means that your periodic interest rate will be 0.044% per day. You probably think this isn’t a lot, but over a month or a year, it can really add up, depending on your balance sheet.
Once you know your periodic interest rate, you need to figure out what the average daily balance on your card was. Let’s say you have a balance of $ 2,000 at the beginning of the month and you don’t pay any of it for the first 15 days. Then payday comes and you can pay $ 500 on the 16th. Then you pay another $ 500 on the 25th of the month. This means that your average daily balance will be (2000 x 15 + 1500 x 9 + 1000 x 6) / 30 = $ 1650.
Now that you know what your periodic interest rate will be and you know your average daily balance, you can add them together to figure out what the monthly interest rate would be $ 1,650 x 0.044% x 30 = $ 21.78.
What can affect the annual interest rate of your credit card?
Most credit cards indicate that they use a variable annual interest rate. This means that the rate can move up and down depending on various factors. Some of these factors are under your direct control, while others are influenced by external factors. Just keep in mind that the Cards Act requires you to notify you of any rate changes 45 days in advance.
What is in your control is your creditworthiness. When you apply for a credit card, the issuer will want to make sure that you can get back the money you borrowed. They can also look at your FICO score, among other things. The higher your scores , the lower your annual percentage rate will be. (Not sure where your finances are now? You can view two of your credit ratings for free on Credit.com.)
However, another factor is the so-called base rate. It is defined as the lowest interest rate at which people can borrow commercial loans. When the Federal Reserve changes rates (as it did very recently), it can positively or negatively impact the credit card’s annual interest rate. If the Fed raises rates, your annual interest rate could rise. If the Fed cuts rates, your annual income could drop.
By understanding how your credit card company calculates the interest on your card, you will become a more empowered consumer and will better appreciate paying off your statement balance in full each month.