How is credit card interest calculated?

Posted by admin in Credit Cards on 02 9th, 2010 | no responses

At a high level, credit card interest is calculated by:

• the balance on your account
• multiplied by
• an interest rate

Let’s look at the two components (the account balance and the interest rate) in a little more detail.

The best credit cards provide grace periods before the interest kicks in.  If you charged something one day and paid off the balance before the grace period expires, you would not have to pay any interest on that card.  If, however, you already carry a balance on your credit card, you usually will not get a grace period for any new charges. But you could always do a credit card balance transfer. It depends really, on what method the credit card company uses to determine the account balance.

Account Balance

Credit card companies do not use the same balance when figuring out how much you owe in finance charges.  Here are the most common ways the account balance is determined:

• Ending balance – when you make new charges or make payments to your account does not matter.  The ending balance is used as is.  For example, the following two scenarios would result in the same ending balance:  a) You had a charge on the card for most of the month but paid it off a day before the new statement came out.  b) You had a charge on the card that you paid off on the first day of the billing cycle.
• Previous balance – this means that the balance at the beginning of the billing cycle is used.  Any new charges that billing cycle are not included in the account balance for determining the interest rate.
• Average daily balance – the balance each day of the billing cycle is added together.  The sum is divided by the number of days in the billing cycle. This gives you more credit if you made payments early in the billing cycle or if you charged new charges later in the billing cycle. Conversely, if you charged early in the billing cycle, it raises the average daily balance or if you made payments late in the cycle, the average daily balance is higher.
• Two-cycle average daily balance – calculated like the average daily balance but over two cycles.
• Adjusted balance – this is the most favourable to the cardholder because you get credit for any payments made but you are not dinged for any new charges that month.

Interest Rate

Most credit card companies advertise the APR (the annual percentage rate) but that rate is not what is used to calculate the monthly interest rate. The APR is divided by the number of billing cycles (usually 12) and the resulting percentage is used to calculate the finance charge.  For example, if the APR is 12%, the monthly rate used to calculate the interest charge is 1%.