Learn How Issuers Calculate Your Interest

Monday, July 29th, 2013

Every time you check your monthly credit cards statement you see some numbers under “Interest” in it, which you know you will have to pay off in the end. Understanding how interest is calculated will help you use your card more effectively. Also, to be an educated consumer is always better than to be unaware one.

Credit card interest basics: if you pay off your entire balance each month, you won’t pay any interest. However, it is important for all credit card holders to know their interest rates, and whether those rates are fixed or variable.

Variable interest rates change depending on prime rate. Most credit card issuers take Wall Street Journal prime rate to calculate the variable rate. The CARD Act of 2009 ensures that issuers and banks notify consumers before raising the rates.

For most people their interest rate, or annual percentage rate (APR) falls between 12.99% and 29.99%. That percentage usually works out to a figure that is a bit higher when the interest is factored into your balance. Most credit card issuers use an average daily balance to calculate the interest charges. That is, your interest is compounded based on your daily balance.

Let’s determine the average daily balance (ADB). Say that in a 30-day period you have a $1,500 balance carried over from the previous month. You do not use your credit card at all during the month, but on the 16th day you make a payment of $500. Thus, your balance for days 1-15 is $1,500, and the balance for days 16-30 is $1,000. Add up the total daily balance for the month, and then divide that number by the number of days in the period to get daily balance.

(15*1,500)+(15*1,000) = 37,500

37,500/30 = 1,250

Now, calculate your periodic interest rate (PIR). If your APR is 16%, divide that by 365 (number of days in the year):

16% / 365 = 0.044%

Your PIR comes out to 0.044%. Next, multiply your PIR by your ADB, then multiply that number by the number of days in the period:

1,250 * 0.044% = 0.55

0.55 * 30 = 16.5

Your interest charge for that month is $16.5.

Now when you understand how interest charge is calculated, keep in mind the following things. Your interest is charge from the date of purchase, not from the beginning of the next month. There is no grace period unless you pay off your balance in full at the end of the period. And the CARD ACT of 2009 stipulated that credit card statements should include a section where you can see how long it will take you to pay off your card if you only pay the minimum balance. Pay attention to this section and make plans to pay off your balance within a reasonable amount of time.

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