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How Is Credit Card Interest Calculated?

It is the horrifying email or mail that you have dreaded and has kept you up at night…the baffling calculations that keep on confusing you despite running the numbers again and again. The credit card interest is calculated, which you want to understand and make sense of. It seems like any company these days is issuing their own credit card to help you spend more. The offers provided are often too attractive to say no to, but before jumping the gun, make sure you understand how interest rates are calculated on your credit card.

How to Calculate Credit Card Interest

Calculating credit card interest should be broken down into a simple three-step process.

1. Calculate your Daily Periodic Rate (DPR)

When you receive offers for various credit cards, the issuer is required by law to state the Annual Percentage Rate (APR). This is also the interest rate that is identified in your statement.

However, interest on your credit card is accumulating on a daily basis, so you’ll need to convert the APR to a daily rate (DPR). In order to do so, simply divide the APR by 365. For various reasons some banks divide by 360, but the difference is marginal and we will therefore ignore that. The result is called the periodic interest rate, or sometimes the daily periodic rate.

2. Calculate your Average Daily Balance

When you open your statement you can see the days included in the billing period. These are the days where interest accrues, and hence your interest charge depends on your balance on each of those days.

The statement always starts with an unpaid balance — the amount you have withdrawn and carried over from previous months. When you make a purchase, the balance goes up; when you make a repayment, it goes down. Using the transaction information on your statement, go through the billing period, day by day, and write down each day’s balance.

Once you’ve done that, add up all the daily balances and then divide by the number of days in the billing period. The result is your average daily balance.

3. Calculate your Credit Card Interest

The final step is to multiply your daily rate (DPR) from step 1 by your average daily balance from step 2, and then multiply that result by the number of days in the billing period.

How Is Credit Card Interest Calculated? Featured Image

How Compounding Interest Changes the Interest Rate You Pay

Depending on whether your credit card issuer compounds interest daily, monthly, or quarterly, your actual interest charge might differ slightly from this calculated amount. Compounding is the process of adding the accrued interest into your unpaid balance so that you are paying interest on interest. The more often interest compounds, the more interest on the interest you will end up paying as the total outstanding balance increases.

Compounding interest is the reason you could pay more than your APR in interest. For example, say your average daily balance was exactly $1,000 for the entire year. If the bank had an 18% interest charge just once at the end of the year, you’d pay $180. But since your interest compounds, you’d actually be the hook for something closer to $195. Compounding interest works like the snowball effect and should be managed properly. We suggest taking these two simple steps into consideration:

1. How Does Credit Card Issuers Determine Interest Rates?

Traditionally, credit card issuers offer a fixed APR across their customer base, while others offer a variable APR – typically a range – based on the specific customer’s credit rating. One’s credit rating is dependable on debt, owned assets, age, employment among other factors. So be sure to create a clear overview of these factors, as they determine how credit card issuers ‘see’ you as a potential customer. The less debt, more assets, younger age, and stable employment with a good salary, the better credit rating you can expect to have. With a good credit rating the credit card issuer will offer you a low interest rate on the credit.

However, it is not purely that simple. We also have to count on macroeconomic factors such as the prime rate – the interest rate in which banks charge their largest clients. An increase in the prime rate will usually result in an equivalent increase in the APR, unbiased whether the APR is fixed or variable. Last but not least, the type of credit card also has an impact on the APR. One credit type like the Reward Card e.g. is usually offered with higher APRs.

2. How Can One Improve the APR Offered?

As stated in step 1. the vast majority of the factors that credit card issuers use to rate your credit score, are manageable by yourself. When you have a good credit score, credit card issuers will offer you good credit card options.

However, if you are in the process of leaping into a better credit score, there are some effective actions you can take upon yourself:

  • Settle your monthly credit card bills in full each month. This will ultimately also make you pay less compounding interest.
  • If not possible to settle the whole monthly payment, then settle more than the minimum required payment. This will also ultimately make you pay less compounding interest.
  • Increase your payment schedule to more than the minimum required monthly payments. This will not only have a positive psychological effect but also reduce your average daily balance.

After these steps, going onward, you will be in a better position to improve your credit card agreements and optimize your money management. Happy hunting, camper!