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How Does Credit Card Interest Work?

Credit card interest occurs when a user doesn’t pay their card’s monthly balance in full. The amount you pay on top of each dollar that remains unpaid is considered a card’s “interest rate.” This amount must be stated in the terms and conditions of a card’s application so that you have the information readily available. 

To calculate the dollar amount you’ll pay in interest for any given month, follow these steps (which we expand on below):

  1. Find your average daily rate 
  2. Find your average daily balance 
  3. Multiply your answers from step 1 and step 2
  4. Take this number and multiply it by the number of days in the billing cycle

Follow along below to dive into a detailed look at how credit card interest works.

What Is Credit Card Interest?

Credit card interest is the amount you’ll pay if a balance isn’t paid off by the due date. This is how credit card companies make money. Think of this as the “subscription fee” to borrow their money.

Some cards have high interest rates and some have low rates. Typically, the lower your credit score, the higher the interest rate will be. You should be wary of using cards with high interest rates, as this can quickly compound into high amounts of debt should balances not be paid off in a timely manner. If that’s the case, you may want to consider canceling your credit card

How Is Credit Card Interest Calculated?

There are two key elements to factor in when determining your card’s interest rate: average daily rate and average daily balance. When multiplied together, you’ll get the given period’s interest payment — that is, the extra dollar amount you’ll owe should you not pay it off in full.

Here’s an in-depth look at calculating your credit card’s monthly interest payment. We also walk through an example calculation you can easily apply to your personal finances.  

1. Calculate Your Average Daily Rate

First, you’ll need to calculate the amount of interest you’re paying daily throughout the entire year. Simply divide the annual interest rate (this is usually the percentage a card company will give you in the contract) by 365. 

Example: For an annual interest rate of 15%

  • Take .15 (annual interest rate) and divide it by 365 (total days in a year)
    • .15 / 365 = .00041096 
    • Average Daily Rate = .00041096 

Write this amount down for use in a couple of steps.

2. Calculate Your Average Daily Balance

To calculate your average daily balance, you’ll need your latest credit card statement. Next, follow these steps below:

  1. Write down your ending balance day by day
  2. Add each daily balance together
  3. Divide the total by the number of days in the current billing cycle

Example: 

  • Add each daily balance together
    • Day 1 ending balance: $100 
    • + Day 2 ending balance: $105 …
    • + Day 30 ending balance: $1,000 
    • = $6,100
  • Divide by the total number of days in the billing cycle
    • $6,100 / 30 days = $203.33
    • Average Daily Balance = $203.33

3. Multiply Average Daily Rate by Average Daily Balance

This step is simple. Multiply your answer from step one and step two.

Example:

  • Average Daily Rate (from Step 1): .00041096
  • Average Daily Balance (from Step 2): $203.33
    • .00041096 x $203.33 = .084

4. Calculate This Cycle’s Interest Owed

Finally, to find the interest payment for a given billing cycle, you’ll want to multiply your answer from step three by the number of days in the billing cycle (this is the same number you used in step two to find your average daily balance). 

Example: 

    • Answer from Step 3: .084
    • Number of days in the billing cycle: 30
      • .084 x 30 = 2.52
      • Interest to be paid for this billing cycle = $2.52*

*Note: This amount starts compounding each day if the balance is not paid in full. 

Interest Rate vs. APR

When it comes to credit cards, interest and APR are the same. With other loans, the interest rate determines the cost of borrowing the amount you request. APR, then, is an annualized rate of interest that includes certain fees as “finance charges.” APR is intended to allow consumers to comparison shop based on the true cost of credit and can give a more accurate view of what to expect.

How to Find Your Credit Card Interest Rate

To find your card’s annual interest rate, look at your contract or application. Remember, it may be listed as APR as the two are interchangeable when referring to credit cards.

The amount will be expressed as a percentage, and this is how much you’ll pay on top of any balance should you not pay off the full amount.

3 Ways To Avoid Paying Credit Card Interest

There are a few strategies that can help you avoid paying high interest on your credit card payments, and in some cases, pay no interest at all. 

It’s important to know these tactics to avoid spiraling into uncontrollable credit card debt. Rember, balances carry over month-to-month and can get exponential in a short period of time.

Pay Balance In Full

The best way to avoid credit card interest is to pay your balance off completely at the end of each billing period. Because interest is built on remaining balances, without one, there’s nothing to charge for (think of it as multiplying by zero).

Never Overspend

Only charge what you can realistically pay off at the end of each cycle on your credit card. Even missing one payment can start a domino effect of interest-heavy payments down the line. Stick to a budget and know what you can afford, especially when dealing with credit cards. 

Use Your Card For Necessities

To help budget with your credit card, only use it for needs (e.g. groceries). This money will have to be spent regardless, so make it much easier to avoid interest by paying off the balance at the end of the cycle. This practice also encourages a healthy credit score. 

Thoroughly understanding your contract with a credit card company is the best place to start when determining how credit card interest works. Many times it’s a uniform process, however, each company will tack on their own terms and conditions. By understanding the basics highlighted above, you can make more informed decisions about which credit cards are best for you.

The post How Does Credit Card Interest Work? appeared first on MintLife Blog.