How Credit Card Interest Rates Are Calculated
Last Updated: July 19, 2017
When you are approved for a credit card, it comes with an APR, or annual percentage rate. It’s this rate that’s used to determine how much interest you’re charged if you carry a credit card balance. But its use isn’t as straightforward as you might think. Here’s how credit cards interest rates are calculated using your daily periodic rate and average daily balance.
Turn APR Into a Daily Periodic Rate
Though it’s called an annual percentage rate, you’re actually charged interest on a daily basis. To do this, credit card issuers use the APR to determine a daily periodic rate.
To find your daily periodic rate, they take your APR and divide it by the number of days in the year – 365, of course. Well, I say “of course” but there are actually issuers that use 360 days instead. For the purposes of this example, let’s stick to the one that makes the most sense (i.e., the actual number of days in a year).
If your APR is 15 percent, divided by 365, then your daily periodic rate is .041 percent.
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Figuring Your Average Daily Balance
Once they have your daily periodic rate, it gets applied to your average daily balance.
To find your average daily balance, they look back at the balance you’ve carried every day over the course the month.
Let’s say your balance was $500 the first 15 days. Then you made a payment of $250, bringing the balance down to $250 for the other 15 days of the month.
In this example, your average daily balance would be figured like this:
1) Multiply $500 by 15 days = $7,500
2) Multiply $250 by 15 days = $3,750
3) Add $7,500 and $3,750 = $11,250
4) Divide $11,250 by 30 (days) = $375
$375 is your average daily balance for the month.
Figuring Your Interest Charge
How your interest gets calculated depends on whether interest gets compounded monthly or daily.
If your credit card issuer compounds interest on a monthly basis, then that would mean multiplying $375 (your average daily balance) by .041 percent by 30 (the number of days in the month) making your interest charge $4.61.
If your credit card issuer compounds interest on a daily basis – which is far more common these days – then your interest charge is going to be higher. Here’s how that works:
At the end of day one, you’re going to be charged the .041 percent on whatever balance you’re carrying. If it’s $500, then the interest charge is 21 cents. That 21 cents gets tacked on to your balance. So, on day two, you’re going to be charged interest on $500.21. You can see how that would start to add up over the course of the month. It’s in this way that the interest you actually end up paying over the course of a year can be higher than your APR.
Minimizing Interest Charges
The best way is to avoid interest charges altogether is by paying your balance in full every month. Thanks to credit card grace periods, you will be charged zero interest as long as you pay the balance down to zero by your due date.
If you know you can’t pay off the full balance by your due date, the second-best way to minimize interest charges is to pay as much as you can. Not just on your due date, though. As soon as you make a new charge to your credit card, start paying it down right away. Make two, three, even four payments if you can over the course of the month. The goal? To bring that balance down as much as possible so you can minimize the interest charged, especially important if it’s compounding on a daily basis.
How to Get Out of Credit Card Debt
If you’re drowning in it, your interest charges are going through the roof. So if you’re not already, start digging yourself out of debt.