How Is Your Credit Card Interest Calculated?
If you carry a balance on your credit card month after month, you’re likely paying interest. First things first: It’s best to avoid charging this interest altogether. Otherwise, understanding how these percentages are calculated can help you better manage your credit costs.
Interest rate
Interest rates on credit cards are usually expressed as an annual percentage rate (APR). This is the rate used to calculate the amount of interest you’ll pay over the course of a year, based on your average daily balance. The higher the APR, the more you’ll end up paying in interest.
Average daily balance
Most credit card issuers use the average daily balance method to determine interest rates. This takes into account your balance for each day of the billing cycle.
For example, let’s say you had a balance of $1,000 for 15 days and then you paid it down to $500 in the remaining 15 days of a 30-day billing cycle. Your average daily balance will be $750 (($1000 x 15 days) + ($500 x 15 days) / 30 days).
Interest calculation
To calculate the actual interest charged, the credit card company uses the following formula:
Accrued Interest = (Annual Percentage Rate / 12) x Average Daily Balance
So, if your APR is 18% and your average daily balance is $750, the math would be:
(0.18 / 12) x $750 = $11.25 in interest for this billing cycle.
Compound interest
One costly factor is that unpaid interest from previous cycles is added to your balance, meaning you’ll end up paying interest on interest over time. What’s magical for your savings is devastating for your debt. This snowball effect is why it’s best to pay off your credit card balances quickly.
Grace period
Luckily, you can minimize interest fees by knowing your card’s grace period . If you pay your statement balance in full each month during the grace period, you will not be charged interest on new purchases for that billing cycle. Interest calculations only apply if you carry over a balance after the due date.
By understanding the methods used, you can see how reducing your average daily balance and taking advantage of interest-free grace periods can minimize the amount of interest you pay on your credit card balances.