Yahoo Finance How Credit Card Companies Calculate Interest
Here's the first thing you should know about credit card interest: It's completely avoidable. If you pay your credit card balance in full every month, you'll probably never owe any interest.
The second thing you should know: If you don't pay in full every month, carrying a balance -- even just for a day -- could cost you.
At first, the charges are tiny. Say you carried a $1,000 balance just long enough to accrue a day's worth of interest. Your interest charges on that balance would be roughly equal to the price of two gumballs. No big deal.
[See: 10 Easy Ways to Pay Off Debt.]
But if you're starting with a larger balance, and paying it down as slowly as possible, these daily interest charges can balloon your debt into something unrecognizable.
"If you make the minimum payments, the credit card company wins," says Ed Mierzwinski, who has lobbied for credit card reforms as the consumer program director of the U.S. Public Interest Research Group, a group of nonprofits. In some cases, he says, "it could take you up to 30 years to pay off your balance on your card."
Credit card interest adds up daily. We usually talk about credit card interest in yearly terms -- probably because credit cards come with advertised APRs, or annual percentage rates. These rates tell us how much interest we can expect to be charged when carrying a balance over the course of 12 months, rather than in a single day. But the vast majority of credit card issuers -- including the 10 largest issuers in the U.S. -- calculate interest on a daily basis, using daily interest rates.
Among the largest issuers, half say they use a method of calculating interest called the "average daily balance method including current transactions." The other half use a similar method called "daily balance method including current transactions."
For the sake of our example, let's focus on the average daily balance method. To keep it simple, suppose that you use your card only for purchases -- not balance transfers or cash advances, which come with different interest rates -- so you have only one APR. Here's how your issuer might calculate your interest.
1. Your issuer translates your card's APR into a daily rate. Your issuer's first step is to find out how much interest will accrue each day. To do this, it converts your card's APR into what's called a daily periodic rate -- usually, by dividing the APR by 360 or 365, according to the Consumer Financial Protection Bureau. If your card's APR were 18.25 percent, for example, and your issuer divided that by 365, your daily periodic rate would be 0.05 percent.
[See: 8 Ways to Maximize Your Credit Card Rewards.]
2. Your issuer calculates your average daily balance. Over the course of a month, your credit card balance might have more ups and downs than the stock market. With this method, your issuer turns all those ups and downs into a single number: your average daily balance. (The alternative calculation method calculates your interest by approximating your balance for each individual day.)
Your issuer finds that average by adding up all your daily balances for the billing cycle, plus new purchases the day they're made, minus any payments and credits. It then divides that total by the number of days in the billing cycle. The larger your average daily balance, the more quickly your interest charges will climb.
For this example, we'll say your average daily balance is $1,000.
3. The compounding begins. The average daily balance method "will indicate that the previous day's interest will be added to each day's balance calculation," says Nessa Feddis, senior vice president for consumer protection and payments at the American Bankers Association. "In effect, this means that the interest is compounded daily." The same goes for the daily balance method. In fact, each of the 10 largest issuers refers to daily compounding in their disclosures.
Finding how much you owe on the first day of the billing cycle with the average daily balance method is easy: Just multiply your average daily balance by your daily periodic rate. In this example, that would be $1,000 times 0.05 percent, or 0.0005, which gives you an interest charge of 50 cents on day No. 1. That's the two gumballs mentioned earlier.
After that, it gets trickier. The 50 cents gets added to your original $1,000 balance, making the second day's starting balance $1,000.50. When calculating the interest for day No. 2, your issuer multiplies $1,000.50, the new balance, by 0.0005, which gives you another 50 cents, plus a fraction of a penny. After adding that on, the third day's starting balance becomes $1,001. And so on.
By the end of a 30-day billing cycle, assuming you didn't make any new purchases or payments, you'd owe $15.11 in interest. It's no longer gumball money. It's enough to get you brunch at a nice restaurant. But the bulk of that interest is attributable to the size of your balance. Only 11 cents of the total comes from daily compounding.
[See: What to Do If You've Fallen (Way) Behind on Your Credit Card Payments.]
How to pay less in interest. The phrase "daily compounding" sounds scary, but it doesn't increase your total interest by a whole lot -- unless you're carrying a large balance for a long time. Then, as you can see, it could dig you a little deeper into debt with every passing day.
You can't control everything about the way your issuer calculates interest. But there are two parts of the formula you do have some say over: your credit card's interest rate and your balance.
If you want to trim the interest you pay, consider transferring your high-interest balances to a card with zero percent balance transfer APR. If you can qualify and move your balances over -- usually, for a 3 percent to 5 percent fee -- you can get up to 21 months interest-free on that balance. That gives you a lot more time to pay down your debt, potentially saving you hundreds of dollars in interest payments. The catch is that most balance transfer cards require applicants to have good credit. If your credit is suffering because of your debt, or for another reason, you might not be approved.
The second part of the formula you can influence -- making your balance smaller -- doesn't require good credit, but it may take some planning. Make it your mission to pay down as much of your credit card balance as you can afford. If you have multiple cards with different APRs, paying down the highest-interest balance could save you the most money. Whenever you can, pay more than the minimum.
Get back into the habit of paying your credit card balance in full every month as soon as possible. The sooner you can pull that off, the sooner you can put an end to ever paying credit card interest.
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