Credit Card Interest Calculation: Your Essential Guide

Knowing how credit card issuers calculate interest can help you understand the true cost of your debt. Here’s what you need to know about how those interest charges are calculated.

What Is an APR?

The annual percentage rate (APR) is how much interest you’d pay on a yearly basis if you didn’t make any payments or changes to your balance. For credit cards, the APR is almost always variable, which means it can change over time.

A variable APR could go up or down based on the prime rate. The prime rate is the interest rate that banks charge their best customers. When the prime rate goes up, so does your APR.

Your credit card company may also raise your APR if you make a late payment or go over your credit limit.

What Is Average Daily Balance?

Your average daily balance is how much you owe on your credit card on any given day, divided by the number of days in that billing period.

For example, let’s say you have a balance of $1,000 and interest is charged daily. You make a payment of $100 on the 10th day of the billing period. The next day, you charge $50 to the card.

Your average daily balance would be:

((10 x $1,000) + (11 x $950)) / 21 = $976.19

How Is APR Calculated?

To calculate how much interest you’ll owe for the billing period, your credit card company will multiply your average daily balance by the daily periodic rate.

The daily periodic rate is your APR divided by the number of days in a year (365). So, if your APR is 15% and you have a balance of $1,000, your daily periodic rate would be:

15% / 365 = 0.041%

To get your total interest charge for the billing period, your credit card company will multiply your average daily balance by the daily periodic rate. In this case, it would be:

$976.19 x 0.041% = $0.40

Keep in mind that this is just an estimate of how much interest you’ll owe. Your actual interest charge may be more or less, depending on the number of days in the billing period.

How Can I Avoid Paying Interest?

You can avoid paying interest on your credit card balance by paying your entire balance before the grace period ends. The grace period is the time between when your bill is due and when interest is charged on your balance.

For example, let’s say your billing period ends on the 10th of the month and your bill is due on the 25th. If you pay your balance in full on the 25th, you won’t be charged any interest for that billing period. But if you don’t pay your balance in full, you’ll be charged interest on the outstanding balance, starting from the date of purchase.

Some credit cards have a grace period for cash advances and balance transfers, but not for purchases. That means you’ll be charged interest on those transactions from the date of the transaction, even if you pay your balance in full by the due date.

To avoid paying interest, it’s important to understand how your credit card company calculates your balance. Some companies use the average daily balance method, while others use the adjusted balance method.

The adjusted balance method subtracts payments and credits from the balance at the beginning of the billing period. So, if you have a balance of $1,000 and you make a payment of $100 on the 10th day of the billing period, your adjusted balance would be $900.

The average daily balance method, on the other hand, takes the beginning balance and adds new charges and interest charges, then divides that by the number of days in the billing period. So, in our example, your average daily balance would be:

((10 x $1,000) + (11 x $950)) / 21 = $976.19

As you can see, the two methods can produce different results, so it’s important to know which one your credit card company uses to calculate your balance.

Variable vs. Fixed Interest Rates

Most credit cards have variable interest rates, which means your APR can go up or down over time. The prime rate is the interest rate that banks charge their best customers and is used as a benchmark for calculating interest rates on credit cards and other loans.

When the prime rate goes up, so does your APR. Your credit card company will generally disclose how your APR is determined and how often it can change. For example, it may be based on the prime rate plus a certain percentage.

Some credit cards have fixed interest rates, which means your APR will remain the same for the life of the loan. This can be an advantage if you’re carrying a balance from month to month and you want to know how much interest you’ll be charged.

But keep in mind that even if your APR is fixed, your credit card company can still change other terms of your agreement, such as your annual fee or the rewards you earn.

Minimum Interest Charges

Even if you don’t carry a balance from month to month, you’ll still be charged interest on any new purchases if you don’t pay your balance in full by the due date. And, most credit card companies will charge a minimum interest charge if you owe any interest for the billing period.

For example, let’s say your APR is 15% and you have a balance of $100 at the beginning of the billing period. If you don’t make any new purchases or take any cash advances during the month, and you pay your balance in full by the due date, you won’t be charged any interest.

But if you only pay $90 by the due date, you’ll be charged interest on the $10 outstanding balance. And, since your APR is 15%, your minimum interest charge would be $0.50 (15% x $10).

How can I lower my credit card’s interest rate?

If you’re carrying a balance from month to month, you may be able to lower your interest rate by asking your credit card company for a lower APR. While there’s no guarantee that your request will be approved, it’s always worth asking.

You may also be able to transfer your balance to a new credit card with a lower interest rate. But keep in mind that most balance transfer offers come with a fee, typically 3% to 5% of the amount transferred. So, you’ll need to do the math to see if a balance transfer makes sense for you.

Finally, remember that the best way to avoid paying interest is to pay your balance in full and on time every month.