How does credit card interest work? Secret Exposed!
Whether you are holding credit card or you are about to apply for a new one, this topic how does credit card interest work is very crucial. Everything about credit cards revolves around interest. Unfortunately, we have many people carrying card balances and groaning under the weight of card debts who do not know anything about how credit card interest is calculated. This makes me remember when I was going through an induction/orientation programme in my new place of work. It was a large organization with many departments. I needed to move from one department to another where I would be taken through their processes and procedures. It was actually an enlightening programme. But there is something that took me aback. When some of the people I visited told me what they did, my question would be, “why is it done that way?” The common answer I got was “that is how it is being done here”. Of course, I was not disputing that. “My question is that, why is it done that way”, I would reinstate. Surprisingly, the majority of people that attended to me could not provide me any definite answer. This may baffle you. But before you start blaming anybody, I want to ask if you have ever asked this question: How does credit card interest work?”
Or, maybe I should frame it in a different way. Let me be the one to ask you the question. I will put you in a position of somebody who has been in a system while I am a new comer. Then, I am here to get insightful information about the credit card you have been using. So I am now asking you, how does credit card interest work? Can you give me a definite answer? Possibly, you may not be able to give me a definite answer. Well, you don’t need to feel bad about this. I want to believe that you are reading this article so that you can have a better understanding on how your credit card interest is calculated. The truth is that, you are alone. A lot of us carry cards. We receive our card statement every month. If you carry any balance beyond twenty one or thirty days, depending on the terms of your card, you are charged interest. Then, we just accept any amount indicated as interest charges on the statement. Has it ever occurred to you that the interest amount might be inaccurate? Credit card companies like people like that. That is not to say that they might be cheating you. But the truth is that if you know how credit card interest work or calculated, you may have a rethink about your credit card balances or how and when to pay your balance.
How does credit card interest work?
In most cases, card holders are used to the term APR meaning Annual Percentage Rate. This is the interest rate that is applicable to your credit card. The APR on your card will depend on the type of the card you hold and your credit score among others. But generally, reward credit cards usually attract higher APR than regular cards. How your APR is determined is not the main focus for today. But the problem with this rate is that, it is expressed in annual percentage. Unfortunately, credit card interests are not calculated on annual basis. It is calculated on a daily basis. This rate is called daily periodic rate. What this means is that, if you have unpaid balance on your card, your card issuers will not wait till the end of the month before they slam interest on you. The reason is that, your balance may fluctuate within the month. You may make payments or further purchases within a month which have tendency of reducing or increasing your credit card balance. For example, if your credit card opening balance is $1,500 and you make a payment of $1,300 a day before your statement date. By the time your card statement will be issued at the end of the billing cycle which is just a day after you made the payment, the balance on your card will just be $200 only. So, some customers usually have this conception; they think that the interest charge for the month will just be on $200. It doesn’t work that way. Credit card companies are smarter than that.
Example of how credit card interest is calculated
I will still use the example above but with more other information added. It is assumed that you had an unpaid card balance of $1,500 at the beginning of your billing cycle with 14% APR. I want to assume that you don’t make any additional purchase within the month while you are able to pay off $1,300 on the 29th day into the billing cycle. Below is how your credit card interest charge will be calculated.
Read Also: See How High Interest Rate Is Killing You
We need to first determine your daily periodic rate (DPR). In order to get this, you will need to divide your card APR by the number of days in a year. The number of days in a year is 365. However, this varies from one credit card Company to the other. Some will use 365 days while some will use 360 days. This is one of the things you need to find out when applying for a credit card. It is to the advantage of customers when 365 days is applied instead of 360 days. In this example, we shall use 365 days.
Daily periodic rate will be 14/365 = 0.03836%.
Before we continue with the calculation, you need to bear in mind that your credit card balance did not remain the same all through the month. Therefore, you need to find out your average daily balance. This is the balance which the credit card company will use to calculate your daily interest by applying your daily periodic rate.
So, within the first 29 days billing cycle, your daily credit balance remained $1,500 while you carry just $200 for the remaining one day. Therefore, your interest charge for the month will be calculated as follows:
($1,500 x 29 days x 0.03836%) + ($200 x 1 day x 0.03836%)
=$16.6866 + $0.0767 = $16.76
Another way to calculate this is to first of all find out the average day balance before you multiply it with the daily periodic rate and then the number of days in a month. You will still get the same answer. Let’s try it out.
Average daily balance = ($1,500 x 29 days) + ($200 x 1 day) =
($43,500 + $200)/30 days = $1,456.67 average daily balance
You can now apply your daily periodic rate of 0.03836% to your $1,456.67 average daily balance and then multiplied by the number of days in the month
= $1,456.67 x 0.03836% x 30 days = $16.76
For people who are not good at calculation, you can choose the method you are more comfortable with. At least, you can see that the two methods of calculating the card interest lead to the same answer.
Please note that your card average daily balance is a function of the transactions that you carried on with your credit card within a billing cycle while your daily periodic rate is directly affected by your APR and the number of days used to work out a year. As mentioned, it is advantageous to customers when a credit card company use 365 days to calculate a year. When you make new purchase, your balance will increase. On the other hand, if you repay part of your card balance, the balance will decrease. The point at which you make the transaction within the month will determine the level of impact the transaction will have on your average daily balance. For instance, in the example above, even though a whooping sum of $1,300 was paid off from the beginning credit card balance, the effects it had on the average daily balance is insignificant because the payment was made just a day to the end of the month. Even though the card balance at the statement day was just $200, the average daily balance for the month was as high as $1,456.67. Therefore, the timing of the payment is very relevant. Supposing you only carried the opening card balance of $1,500 just for one day while you made the $1,300 payment on the day following, let’s see what the effect will be on the interest that you will be charged for the month.
I will use our second method in the example above
Average daily balance = ($1,500 x 1 day) + ($200 x 29 days) =
($1,500 + $5,800)/30 days = $243.33 average daily balance
You can now apply your daily periodic rate of 0.03836% to your $243.33 average daily balance and then multiplied by the number of days in the month
= $243.33 x 0.03836% x 30 days = $2.80
Can you see the big difference? So, for people who have been asking how does credit card interest work or how to calculate credit card interest, I believe that you now understand. This is one of the secrets that credit card companies will not want you to know. Making payment at the end of the month is not having the same impact on your card balance as when you make payment on the earlier date. If you are carrying balance on your card, the best thing to do is to pay off any purchase you make on the card as soon as you can. You don’t need to wait till the end of the month before you make payments. This will save interest charges.
Must you pay card interest?
The truth is that you can avoid credit card interest payment completely. How? You can achieve this by ensuring that you don’t carry any balance on your card. If you make full payment on your purchases at the end of the month, you will not be charged interest. However, if you use your credit card to make cash withdrawal, this will be regarded as cash advance. In this case, you may be charged cash advance fee and the interest on the cash advance will start accruing immediately after the transaction. So, if you want to avoid interest charges completely, you should not withdraw cash with your credit card. Instead, you can use your debit card or withdraw from your saving account to make such transactions. Perhaps, if you find yourselves in a situation where you must use your credit card to withdraw cash, you should reduce the amount to the barest minimum while you also ensure that you pay off the amount almost immediately.
For people already having balance on their cards, the best thing to do is to quickly pay off the debt so that you can be free from monthly interest payment. Though your card issuer may not complain as long as you are making your minimum payments, if you truly desire to be out of card debt, you should go beyond minimum payment.
Read Also: You Can Pay off Debt With These Strategies
If you are using balance transfer card, you should ensure that you don’t miss your payment. You may not make purchase with the card either. However, some credit card companies offer 0% introductory APR on purchases. You need to find out from your card company whether you can enjoy 0% introductory APR on your purchases. If you make any purchase with the card, you should ensure that you will be able to pay off the total purchases at the end of the month without affecting your regular monthly payment. Don’t forget that any purchase you make will definitely add to your existing debt. Therefore, you need to be careful about making large purchase with the card. Another thing you may need to know about balance transfer cards is that, they usually attract high apr after the 0% introductory apr has expired. That is one of the reasons you need to ensure that you pay off your balance before 0% introductory apr expires.