If you borrow money from a bank or any other lending institution, you will be required to pay interest to the lender for the money you borrowed. Your interest rate is a way of expressing this cost over a specific period of time, usually a year. And this rate is always expressed as a percentage of the money you borrowed.
Each time you buy something with your credit card, you are in fact borrowing money from your credit card company. And you are expected to repay the money by a specified date. If you don’t repay the amount you owe in full by the payment due date, your credit card company will charge you interest, based on the type of transactions you have made and the total amount of money you spent.
Interest is charged only if you fail to pay up your credit card debt by the payment due date. So, if you always pay the amount owing on your credit card by the payment due date, you won’t have to pay interest. And you may not even care much what your interest is and how it’s calculated. But if you are always paying after the payment due date or take cash advances from your credit card, you sure would have paid interest in the past.
Now, most credit card users have no idea how credit card interest is calculated and charged. Before you start thinking you are being ripped off by your credit card issuer, take your time to read this explanation on how credit card companies calculate the interest rate they charge on users’ cards.
Credit card companies calculate interest using either of two methods: the average daily balance method or the daily balance method. Both methods differ in how they calculate interest rates, but they generally result in the same interest charge.
How Credit Card Companies Calculate and Charge Interest Rates
1. Average daily balance method
The average daily balance on your credit card is calculated as the balance you carried during your statement period divided by the number of days in your statement (usually 30 or 31 days). This calculation is done at the end of the month by adding the up your end-of-day balances for the whole month and dividing by the total number of days in the billing period.
You can calculate the interest charged for the month by multiplying the average daily balance by the daily interest rate, which is obtained by dividing the annual interest rate by the number of days on the year). Then multiply your result by the number of days in the billing period.
Now, let’s look at this example:
You receive a new credit card on June 1. You then make a purchase of $3,000 on June 5. Your June statement, which covers the period between June 1 and June 30 (30-day billing period), has a payment due date of July 19.
Let’s assume that:
- You didn’t pay your bill in full by the due date (July 19), meaning that the interest-free period doesn’t apply to your purchase (read on to understand when interest-free period applies)
- Interest is charged for the purchase date of June 5
- You didn’t buy anything on your credit card during July. When your July statement arrives, it shows an interest charge of approximately $39.50, based on an annual interest rate of 18.5%. If you divide 18.5% by 365, you get a daily interest rate of 0.05068%
Using the average daily balance as explained above:
$3000 (total balance for the month) * 26 days (number of days you carried the balance June 5 to June 30) = 78,000
78,000/ 30 days (total number of days in billing period) = $2,600
So, your average daily balance is $2,600
Total interest charged in July = average daily balance * daily interest * number of days in billing period
= $2600 * 0.05068% * 30 = $39.53
That’s how your $39.50 interest fee was come by.
2. The daily balance method
This method simply calculates the interest owed at the end of each day of the billing period. You can calculate your daily interest charge by multiplying your daily balance by the daily interest rate (0.05068% in our example), and then dividing by the total number of days in the billing period.
And to calculate the interest charged for the month, you multiple the daily balance by the daily interest rate. Then add up the resulting daily interest charges to obtain the amount of interest charged for the month.
Using the daily balance method:
$3,000 (daily balance) * 0.05068 (daily interest rate) = $1.52
Total interest charged = daily balance * number of days in billing period = $1.52 * 26 days
So, you get $39.52, which is almost the same as the $39.53 answer you got earlier.
Note, however, that this calculation can become quite complex if you’re making lots of transactions and payments.
How is your interest-free period calculated?
Your interest rate is typically calculated as the period between your first purchase (June 5 in our example) and your payment due date (July 19). So, you won’t be charged any interest for the purchase you made on June 5 provided you are able to pay your balance of $3,000 by the July 19 payment due date.
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