How Is Interest Calculated?
The numbers listed under "Interest" on your monthly credit card statement might be nothing more than a looming enigma that you know you'll eventually have to pay off. Understanding how interest is calculated is an important approach toward becoming a more educated consumer and using your credit card more effectively. Here's what you need to know.
About credit card interest
First, some basics about credit card interest: If you pay off your entire balance each month, then you don't have to worry about any interest charges. However, it is prudent for all credit card holders to be aware of their interest rates at any given time, and whether those rates are fixed or variable. Variable interest rates are subject to change, and the CARD Act of 2009 ensures that banks notify customers before raising rates. Your interest rate is also known as your annual percentage rate (APR), which for most people falls between 12.99% and 29.99%. That percentage, known as a nominal rate, usually works out to a figure that's a bit higher (an "effective interest rate") once the interest is factored into your balance. The majority of credit card companies use an average daily balance method to calculate interest charges, which means that your interest is compounded based on your daily balance. Tool: APR Calculator
How to calculate interest charges
The first step is to determine the average daily balance. For example, let's say that in a 30-day period you have a $1,000 balance carried over from the previous month. You don't use your credit card at all during this month, but on the 11th day, you make a payment of $300. So, the balance for days 1-10 is $1,000, and the balance for days 11-30 is $700. Add up the total daily balance for the month, and then divide that number by the number of days in the period to get your average daily balance.
(10 x 1,000) + (20 x 700) = 24,000 24,000 / 30 = 800
The second step is to calculate your periodic interest rate. If your APR is 14%, divide that by 365:
0.14 / 365 = 0.00038
Your periodic (or daily) interest rate comes out to 0.038%. Next, multiply your periodic interest rate by your average daily balance, then multiply that number by the number of days in the period:
800 x 0.00038 = 0.304 0.304 x 30 = 9.12
Thus, your interest charge for that month is $9.12.
Things to keep in mind
Now that you understand how to calculate credit card interest charges, there are two things to keep in mind. First of all, your interest is charged from the date of purchase, not from the beginning of the next month. There is no grace period unless you pay off your balance in full at the end of the period, in which case the interest charges are waived. Second, the CARD Act of 2009 stipulated that credit card statements include a section that clearly outlines how long it will take you to pay off your card if you only pay the minimum balance. If you make a habit of only paying the minimum each month, it would benefit you to pay attention to that section and make plans to pay off your balance within a reasonable amount of time.
If you want to minimize the amount of interest that you pay, get a credit card with a lower interest rate. MyBankTracker has a list of the Best Low Interest Credit Cards that you should consider.
Many of these cards also provide low-cost balance transfers, which will help you pay off credit card debt faster through debt consolidation.