How is Credit Card Interest Calculated?
Published June 13, 2018
We recently talked about what you needed to know before getting your first credit card. Now we thought we would dive deeper into some of the other “conditions” credit cards come with. Today we’re talking interest.
Whether you’re about to get your first credit card or you’ve been using credit for years, you know credit cards come with an “annual percentage rate,” or APR, attached to it. But do you know how card issuers come up with that number? What about how interest is calculated?
We’re going to be talking all about credit card interest, how the APR is determined, and how it all works together. Don’t worry, it’s not as complicated as it sounds. Knowing how interest is calculated can really help you understand what carrying credit card debt truly costs.
Interest is calculated by a three-step process:
- CONVERT YOUR ANNUAL RATE TO A DAILY RATE—Interest is calculated on a daily basis, so it makes sense that your annual rate be changed to a daily rate. Do that by dividing your annual rate by 365. This is called the daily periodic rate.
- DETERMINE YOUR DAILY BALANCE—If you look at your statement, it will tell you how many days are included in your billing period. Your rate depends on your balance on each of those days. Using your transaction history, go day by day and write down each day’s balance. Then you need to add it all up and divide that number by the number of days in the billing period.
- BRING IT ALL TOGETHER—Now you will multiply your average daily balance by your daily rate. Then you’ll take that number and multiply it by the number of days in the billing period.
Your calculated amount might be slightly different from your actual charge depending on whether your card issuer compounds interest daily or monthly.
You may be asking how card issuers arrive at the APR you’re given when you apply for your credit card. Normally, your rate depends on your creditworthiness. The better your credit is, the lower your rate is going to be.
Different cards can also influence the APR. Rewards cards have great benefits attached to them, but they tend to come with higher interest rates. Not ideal if you tend to carry a balance month to month.
Credit card issuers charge interest ONLY if you carry a balance from one month to the next. If you’re good about paying your balance off in full, you don’t really have to worry about your interest rate because you aren’t getting charged interest at all.
Obviously, it’s a good idea to try and pay your full balance every month. However, if you normally carry a balance, try making two payments within your billing period. Doing so helps lower your average daily balance thus lowering the amount of interest you’re charged.
Talking about interest isn’t fun but knowing what it does can help you save money in the long run.