The old saying, “There’s no such thing as a free lunch,” applies to credit card debt.
Credit Comes With Strings Attached
Most credit cards come with some strings attached, such as the potential for interest charges and fees. These strings can make a big impact on how much you pay for using your card. The most common expense attached to a credit card is the interest rate charge.
Credit Card Interest
Credit card interest works by charging you for the amount of money you borrow when you make a purchase with your card. If you don’t pay off your balance in full by the due date, you will be charged interest on the remaining balance.
The rate charged on your card is usually expressed as an Annual Percentage Rate (APR) and will vary depending on a number of factors, such as your credit score, the type of card you have, and your overall credit reputation. Credit card APRs are generally variable and can even vary depending on the type of charge. For example, there may be one rate for purchases and another for cash advances.
The main thing to remember with credit card interest rates, is the higher the rate, the more you pay on balances you do not pay in full by the due date.
How Interest is Calculated
Every day counts when you carry a balance on your credit card past the due date. Interest charges are calculated daily, which is why it is so important to strive to pay off your balance in full each month or keep the balance as low as possible. Let’s dig into the details on exactly how interest is calculated.
First, the Average Daily Balance is determined by adding up the account balances for each day in the billing cycle and dividing by the number of days in the cycle. The Number of Days in the Billing Cycle may vary slightly month-to-month.
Next, the Daily Periodic Rate is calculated by dividing the APR by 365, the number of days in a year.
Then, the Average Daily Balance is multiplied by the Daily Periodic Rate to calculate the interest charge per day. And lastly, the daily interest charge is multiplied by the Number of Days in the Billing Cycle.
While it may sound complicated, it is important to understand the how the math works and the impact of carrying a balance. Let’s consider the following example as illustrated in the charts below.
Joe carries an average daily balance of $3,500. His APR is 18%. His monthly interest charge is based on the following factors:
Credit card example
|Average Daily Balance||$3,500|
|Days in Billing Cycle||30|
|Daily Periodic Rate (APR/365)||18%/365 = .18/365 = 0.000493|
|Average Daily Balance||X||Daily Periodic Rate||X||Days in Billing Cycle||=||Monthly Interest Charges|
It’s important to note that various charges such as a purchase or cash advance may incur different APRs. In the example above, only one APR was considered. Carefully review your monthly statements and your card’s terms and conditions to understand how interest is calculated on your account.
Tip from Katie Casey-Macias, CFP®
A credit card in your wallet is not a license to spend. Never take on debt without a plan to pay it back.