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How is credit card interest calculated?
See how some interest charges are calculated, learn how to steer clear of them for good, and find out how taking advantage of grace periods can ultimately become your saving grace.
Transcript
Let's think a little bit deeper about how interest on your credit card is actually calculated for a given billing cycle. And a billing cycle is just a period of time over which the credit card company will give you a statement. And so let’s just say, for the sake of argument, your billing cycle is from the first of the month to until the first of the next month. And we’ll just assume that it’s October, to use as an example.
So let’s just say going into October, you had $100 balance on your credit card. And you continue to have $100 balance. You don’t do any spending, nor do you pay down the card, until October 6th. So let’s say that’s the sixth right over there, and that’s where you go and you buy yourself a nice sweater for $100. And so now you have a $200 balance on your credit card. And once again, that $200 balance, it continues – you don’t do any more spending or paying down. But you had sent a check in a couple of days ago and it finally gets registered with the credit card company on the 20th. And that check was for $150. So it pays down your balance, your balance would now go down from $200, since you paid $150, it would go down to $50. And then you don’t do any more paying, nor do you do any more spending, until the end of the billing cycle, just like that.
So let’s think about how much interest you would have to pay for that period. And just to make things a little bit concrete, let’s say that your annual percentage rate, APR it’s typically called, let’s say that that is 22.99%. I just looked at one of my credit cards, and that is what the APR was. And they always tend to put this .99%; I guess they feel like it looks better than saying 23%.
So let’s think about what the interest charge would be for the spending in this period. And the way that it’s typically calculated is using the average daily balance method. Let me write this down. And one way of thinking about it is, it is exactly what it says. It averages your daily balance for every day in the billing period.
So for example, right over here, we had five days from midnight October 1 until midnight October 6 where we had a balance of $100. So we can write that down – we had 5 days where we had a balance of $100. And then we go from the sixth to the twentieth, so that is 14 days, where we have a balance of $200. So plus 14 times $200. And then finally, going from the twentieth to the first – you could almost do the first as the thirty-second. So this right over here would be 12 days where we have a balance of $50. And we’re going to divide this by the total number of days of our billing cycle. And once again, in October, we had 31 days.
This would be a different number if we were going from the first of February to the first of March. And just to make it clear that this is the average daily balance – I could have written down $100 + $100 + $100 five times, and then I could have done $200 + $200 + $200. So literally for each day that I’m at $100 I would have written $100, but there’s 5 of those. And for
each day that I’m at $200 I could have added $200 to the top part of this fraction. You remember there’s 14 of those, so I just multiplied 14 times $200. And same thing – there were 12 days when I was at $50. I could have said $50 + $50 + $50 and done that 12 times, but that’s just going to be 12 times $50. So our average daily balance is going to be…let’s think about this. This would be $500. 14 times $200 is $2,800. And then 12 times $50 is $600. So let’s see – $500 plus $600 is $1,100 – plus $2,800 is $3,900. And we’re going to divide that into 31 days. So if you summed up your balance for each day you would get $3,900. And so let’s divide. So $3,900 divided by 31 gets us 125.8, I guess if we round to the nearest penny, 81 dollars. So that is equal to $125.81.
This is what your average daily balance would be. Now your credit card company, based on this, can actually calculate what your interest charge should be for that billing cycle. So they’ll take the $125.81, and then they’re going to multiply it by your APR, but adjust it for the number of days in the billing cycle. So you’ll say, "What fraction of the year was this billing cycle?" So they’ll multiply it; so let’s assume that there were 365 days in this year, this billing cycle has 31 days. So 31 divided by 365, and then that times the annual percentage rate. So times 22.99%. And that is going to give us, let’s get the calculator out again, and so I can take this previous answer that I just had and multiply it times 31 divided by 365, times 22.99%, that’s the same thing as 0.2299. And we get an interest charge of $2.46. So $2.46 in interest. Now that’s what we’ll have to pay in interest if we don’t pay the entire balance off in full. But you usually have a grace period.
So if you pay your credit card fully off, and the grace period only applies for traditional credit transactions, not necessarily things like cash advances or not necessarily things like balance transfers. But typically you have a grace period of 21 to 25 days, sometimes it might be even longer than that, where if you pay off your balance in the grace period, if you completely pay this off, if you pay off the $50 in this period, then you won’t have to pay this. If you pay anything less than the complete balance, then some of your payment will go to this interest charge.
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