How Credit Cards Calculate Interest

How Credit Cards Calculate Interest
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Unless you pay your balance in full each month, understanding credit card interest rates and calculation methods is essential. Although the Federal Truth in Lending Act requires credit card companies to tell you the annual percentage rate on your card, how they calculate interest makes a difference in the actual amount. Understanding the process can help you make better decisions regarding the wisdom of carrying a balance.

The Facts

Read the fine print on your credit card application or statement as it provides important information about your APR. Look at whether the card features a variable or non-variable interest rate. If your rate is variable, it can change monthly or quarterly, depending on how often your card issuer updates rates according to the current prime interest rate. Also, look for differing interest rates. Credit cards can, and often do, charge a different APR for purchases than they do for cash advances so make sure you know which rate or rates apply to your balance when calculating interest.

Average Daily Balance

Average daily balance is the most common interest calculation method. The formula is average daily balance x daily periodic rate x days in the billing cycle. Using this method, the company updates your balance each morning to reflect payments or credits to your account. Your card issuer may also add new purchases to your daily balance, depending on the terms of your agreement. When the billing cycle ends, the card issuer determines the daily periodic interest rate by dividing your APR by 365 and your average daily balance by dividing the total daily balances by the number of days in the billing cycle. For example, if your APR is 10 percent, your daily period rate is about .0273 percent. If your total daily balances come to $61,300.00 and there are 31 days in the billing cycle, your average daily balance is $1,977.42. Your monthly interest charge will be about $16.73, or $1,977.42 x .0273 x 31.

Adjusted Balance

Although not as common as the average daily balance method, credit card companies sometimes calculate interest using the adjusted balance method. This method uses the same calculation formula as the average daily balance but differs in how it arrives at a monthly balance calculation. Rather than calculating your balance on a daily basis, in the adjusted balance method, the credit card issuer waits until the end of a billing period and then subtracts payments and credits from the ending balance of the previous month. Purchases you make during the billing add to the balance after calculating interest. This method is the most beneficial to you, as you have until the end of the billing cycle to pay and avoid the interest charges.

Two-cycle Balance

Try to stay away from credit cards that feature a two-cycle balance method of calculating interest. This method uses two billing cycles, rather than one to calculate your average daily balance and does not feature a grace period for purchases you make during the billing period. If you make a purchase at the beginning of a cycle and do not pay your balance in full, interest charges go back to the purchase date.