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How does credit card interest work?

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Understand interest so you can apply for credit cards with confidence.

People make a big deal out of interest rates when applying for credit cards. They tell you interest is important, and that you should carefully compare rates between credit cards.

They’re right, of course. But why are interest rates so important? More fundamentally, what is interest?

In this guide, we demystify how credit card interest works.

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What is interest?

Why is interest such an important feature of credit cards?

To answer this, let’s talk about the function of a credit card. When you make a purchase on your card, you’re borrowing money from your credit card company. Instead of carrying around $500 in cash to buy a new TV, you swipe your card and pay your card company back later.

After you make the purchase, you have two options:

  • Pay back the money you owe immediately.
  • Pay back just a little of the money and continue to carry a balance on your credit card.

Did you know

Your balance is the amount of money you owe on your card.

If you choose to carry a balance on your card — meaning you’re continuing to borrow money — your card provider isn’t going to let you do it for free. For the privilege of borrowing money, you pay your provider interest.

Must read

Interest is money you pay to your lender as a fee for borrowing money.

Types of credit card interest

There are various types of credit card interest you can accrue. These are the most common:

  • Purchase interest rate. This is the interest you are charged when you make purchases with your card. However, you only accrue interest if you don’t pay your balance in full by the end of your billing cycle.
  • Cash advance interest rate. This is the interest rate you are charged when you make ATM cash withdrawals or cash equivalent transactions like gambling.
  • Balance transfer interest rate. This is the interest rate you are charged when transferring an existing credit card debt to a new card.
  • Promotional interest rate. This is also known as an intro APR period on purchases and/or balance transfers. Usually, it’s available for a limited time, with the standard interest rate applying after that. For example, a card may offer you 0% interest on balance transfers for the first 12 months. If you didn’t pay off the balance transfer during the first 12 months, the standard rate for balance transfers would apply to the debt.

How interest is charged

Card companies express interest in the form of an APR or annual percentage rate. For example, your APR could be 15%, which is a standard interest rate across the industry.

This doesn’t mean that your card provider charges you interest once a year. Instead, it applies your APR to your balance either every day or every billing cycle.

There are different methods of calculating interest. The biggest card companies generally use two methods: daily balance and average daily balance.

Let’s go over how these methods work.

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The daily balance method

In your card’s terms and conditions, you may see this method written as “daily balance (including new transactions).” Because interest is calculated every day, your card company begins by finding your daily periodic rate. This is just your APR divided by 365, the number of days in a year.

Every day, your card company multiplies the daily periodic rate by your balance. That gives them your daily interest.

PRO TIP

Card companies don’t always use 365 days to calculate your daily periodic interest rate. They sometimes use 360 days.

The card company adds that daily interest to your balance, resulting in your new current balance. Then the process starts over again the next day.

That’s the gist of it, but take a look at the math in the example below.

An example of the daily balance method

If your APR is 20%, your daily periodic rate will be 20% divided by 365 days — or .054795%. (That’s 0.00054795 on a calculator.)

Let’s say you’re carrying a $5,000 balance on your credit card.

Day Interest
Using interest calculations on Day 1:
  • You’ll be charged $5,000 x 0.00054795 — or $2.74 in interest.
  • That brings you to a new balance of $5,000 + $2.74 — or $5,002.74.
On Day 2:
  • You’ll be charged $5,002.74 x 0.00054795 — or $2.74 in interest.
  • That brings you to a new balance of $5,002.74 + $2.74 — or $5,005.48.

Now, let’s say you make a $200 purchase on Day 3.

With a $200 purchase, on Day 3:
  • Your new balance is $5,005.48 + $200 — or $5,205.48.
  • You’ll be charged $5,205.48 x 0.00054795 — or $2.85 in interest.
  • That brings you to a new balance of $5,205.48 + $2.85 — a total of $5,208.33.

Finally, let’s say you pay off $400 of your balance on Day 4.

With a payment of $400, on Day 4:
  • Your new balance is $5,208.33 – $400 — or $4,808.33.
  • You’ll be charged $4,808.33 x 0.00054795 — or $2.63 in interest.
  • That brings you to a new balance of $4,808.33 + $2.63 — or $4,810.97.

If you do nothing else on your credit card for the rest of the month (and we keep repeating the interest calculation), you’ll accrue $79.98 in interest for this billing cycle.

The process is tedious, but that’s how daily interest works.

How does this look over a calendar month?

DAILY BALANCE METHOD Money Transfers

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The average daily balance method

In your card terms, you may see this method written as “average daily balance (including new transactions).”

Like in our previous method, you start with finding your daily periodic rate.

Next, you find the average of all of your daily balances over the billing period. You do this by adding your balances for every day in the period divided by the number of days in the billing cycle.

Finally, you multiply your daily periodic rate by your average daily balance. Then you multiply the result by the number of days in the billing cycle. This gives you the interest you’ll pay for this billing cycle.

To clarify how this works, let’s go over an example.

An example of the average daily balance method

Like in our other example, let’s say you’re paying 20% APR on a $5,000 balance. Again, the daily periodic rate will be 20% divided by 365 days — or .054795%. (That’s 0.00054795 on a calculator.)

On Days 1 and 2, you don’t do anything with your card, so your balance is unchanged.

Day Interest
On Day 1:
  • Your balance is $5,000.
On Day 2:
  • Your balance is $5,000.

On Day 3, you make a $200 purchase.

With a $200 purchase, on Day 3:
  • Your new balance is $5,000 + $200 — or $5,200.

And on Day 4, you make a $400 payment toward your balance.

With a $400 payment, on Day 4:
  • Your new balance is $5,200 – $400 — or $4,800.

Let’s say you don’t use your card again for the rest of the month. That means on Days 1 and 2, your balance was $5,000; on Day 3 your balance was $5,200 and the balance for Days 4 through 30 was $4,800.

First, we’ll add up the balances for the month:

$5,000 + $5,000 + $5,200 + ($4,800 x 27 days) = $144,800

Then we’ll divide that number by the number of days in the billing cycle:

$144,800 / 30 = $4,826.67
Our average daily balance is $4,826.67.

Now, we multiply our daily periodic rate, our average daily balance and the number of days in the billing cycle.

0.00054795 x 4,826.67 x 30 = $79.34
This means that in our next billing statement, we’ll see a $79.34 charge for interest.

How does this look over a calendar month?

DAILY AVERAGE BALANCE Money Transfers

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Must read: Compound interest costs

The way credit card interest is charged is known as “compound interest” because it is calculated daily. This means that you could end up paying interest on your interest charges. The good news is that you can cut down on interest costs any time you make a repayment because that will also affect the daily interest calculation.

But do you have to pay interest?

credit card interestOne misconception about interest is that you have to start paying it immediately. In fact, most credit card companies give you a grace period during which you can pay off your debt before interest kicks in.

Your card company should list the length of this grace period in its terms and conditions. Terms typically look something like:

Your due date will be a minimum of 21 days after the close of each billing cycle. We will not charge you interest on purchases if you pay your entire balance by the due date each month.

Here are a few examples of how that process works.

Example 1: You pay off your balance in full each month

Let’s say you’ve made $100 in purchases in the first month you open your card (we’ll say it’s January).

  • After the end of January (when your billing cycle ends), you’ll receive your credit card statement. You need to pay back that $100 you charged to your card.
  • Now you have a 21-day period to pay that $100. You pay off the $100 on February 15.

Since you owed $100 but then paid off $100, your balance is $0. In terms of interest, you’re free and clear for now.

There are benefits to this situation:

See the pattern? If you completely pay off your balance each month by the due date, you’ll never owe interest.

Example 2: You don’t pay off your balance in full each month

Again, let’s pretend you make $100 in purchases in the first month you open your card (January).

  • After the close of the billing cycle, you get a credit card statement for $100. On February 15, you pay only $50 toward your balance.

You owed $100 but paid off $50, so you’re still carrying a balance. There are disadvantages to this situation:

As you can see, this is one of the ways you can get into snowballing credit card debt. Carrying a balance can be dangerous.

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The bottom line

We’ve made a lot of calculations in this guide to demonstrate how interest works. However, interest doesn’t really have to be that complicated. Your goal is to keep it as low as possible by paying off your balances as quickly as possible. Use our credit card repayment calculator to find out how long it will take to pay off your balance.

Have any questions?

We know that credit card interest can be confusing. Contact us with any questions.

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