How Is Credit Card Interest Calculated?
Point of Interest: Credit Card Interest
If you understand that using a credit card means you’re effectively taking out a loan every month for the money and are paying for that service, your experience should be positive. Beware of the pitfalls of overusing a credit card and the debt that will accompany it.
Credit cards have exploded in popularity over the past few decades as consumers fell in love with the ability to get things sooner, without having to save up the money needed for the full purchase. While credit cards can be helpful financial tools to navigate life, have you ever wondered, “How does credit card interest work?” If you have, then it’s important that you learn what you’ll be charged for access to these funds as an integral part of your budgeting and long-term financial planning.
What is credit card interest?
Credit card companies are not in the business of charity; the main goal is to turn a profit. In a nutshell, credit cards are like pre-approved short term loans you can use for purchases. The companies let you borrow money to make a purchase now with a promise that you’ll pay that money back later plus a little extra as payment for the service. That little extra is the credit card interest.
How does credit card interest work?
That “little extra” you pay for the use of the extra money is measured as a yearly percentage known as annual percentage rate (APR). With most credit cards, you won’t pay interest unless you carry a balance from one month to the next, meaning you did not pay off the money spent in the previous billing cycle.
For example, if you spend $100 in a month and make no payments, you would carry a balance of $100 over to the next month. If you made a $25 payment, you would carry a balance of $75 to the next month that would be subject to an interest charge. If you pay the entire $100 amount off before the end of the month and billing cycle, you’d carry $0 and be subject to no interest payments with almost all cards.
Credit card interest works on an ongoing and compounding basis. This means that until you pay off your balance, you will continue to incur interest charges each billing cycle that you carry a balance. Keep in mind this also means you’ll incur interest charges on unpaid interest charges that are carried over.
How is credit card interest calculated?
With most popular credit cards, paying off your balance by the end of the month will result in no interest charges. If you carry a balance, though, the way your interest will be calculated will depend on the terms of your credit card agreement. Most popular credit card companies utilize an average daily balance calculation, and your APR is broken down for the billing cycle.
You can see a credit card’s APR prior to making your choice to apply. Based on your spending habits with that particular card, the range of interest you pay each month will vary. Some cards carry a welcome offer to pay 0% interest for a limited time. However, APR is the percentage that reflects the total amount you’d pay in interest if you were to carry the same balance month-to-month for an entire year.
To figure out your credit card interest charge for a single billing period, you’d need to first divide the APR by 365 days for the daily periodic rate. The daily periodic rate is the amount of interest you’ll pay in a single day. If you add up every daily periodic rate for the year, it will equal your APR.
From there, you’d multiply the daily periodic rate by the number of days in the billing period to give you your interest percentage for the month. Lastly, you’ll want to calculate your average daily balance. You can find this by adding up your balance at the end of each day in the billing cycle and dividing by the total number of days in the billing cycle. Take the number you received by multiplying your daily period rate by the number of days in the billing period and multiply that number by the average daily balance. The result is your monthly interest payment.
Here’s what this looks like in practice. Let’s say you have a credit card with a 36% APR. You make a purchase for $1,000 on the first day of the billing cycle and no other purchases or payments for the entire duration of the 31-day billing cycle. Your interest added to your balance at the end of the billing period can be calculated as follows.
Annual Percentage Return (APR) / Days in the Year = Daily Periodic Rate
36% APR/ 365 days = 0.098%
Daily Periodic Rate * Days in Billing Cycle = Monthly Interest Rate
0.098% * 31 days = 0.03038%
Sum of All End of Day Balances During Billing Cycle / Days in the Billing Cycle = Average Daily Balance
$31,000/31 days = $1,000
Monthly Interest Rate * Average Daily Balance = Monthly Interest Charge
0.03038% * $1,000 = $30.38
Your interest for the month would be $30.38. If you didn’t make a payment or purchase the following month, the same calculations would be run, except your average daily balance used for calculations would now be $1030.38.
Avoiding credit card debt
There is nothing wrong with using credit cards to make purchases. That being said, you do need to be smart about how you use credit cards to avoid putting yourself in dire situations. The best way to use a credit card to avoid accruing debt is to make purchases and pay off the balance at the end of every month. With rewards credit cards, this allows you to earn cashback and travel credits without ever paying a penny of interest as long as the balance is paid before the end of the billing cycle.
If you do need to use a credit card for a purchase that you can’t pay back right away, make sure you have a plan to pay back the debt. Since you’d never take out a standard loan without a plan to pay it back, credit cards should be treated the same way. Additionally, be honest with yourself about your credit card usage. If you’re utilizing the service in a responsible manner, great! But if you start to see yourself getting carried away with frivolous purchases on credit that you don’t need and don’t have a plan to pay back, you may want to give up the card for a while.