When you go shopping for a credit card, one of the most important factors you should consider is the amount of interest you’ll pay on outstanding balances. How is credit card interest calculated? To find out, you need to know your current annual percentage rate, or APR, and your average daily periodic balance. You could do the figuring using an online credit card interest calculator, a spreadsheet or a good old pencil and paper. Let’s go over some basics before we see how to apply the credit card APR formula.
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Credit Card Interest Basics
The first thing you should know about credit card interest is that, for virtually all cards, you can avoid paying any interest at all. The trick is to pay for all your new purchases by the very next payment due date. The normal billing cycle is 28 to 31 days, and the period between the end of a billing cycle and the payment due date for that cycle is called the grace period. If you pay the full amount before the end of the grace period, you won’t accrue interest (although there are a few cards available without grace periods – they charge interest starting from purchase date, even if you pay the balance on the payment date). Note that cash advances on your credit card do not benefit from grace periods – interest accrues immediately, often at a different interest rate from that used for purchases. Regulations require that card issuers who employ grace periods ensure that customers receive their bills at least 21 days before the payment date. Interest charges on purchases accumulate if you have an unpaid balance from previous billing cycles. The interest on unpaid balances is calculated every day, based upon a daily periodic rate and the unpaid balance. The daily periodic rate is the card’s APR divided by 360 or 365, depending on the card issuer. The interest you have to pay is based on a compounded rate, meaning you are paying interest on interest. At one time, most credit cards performed monthly compounding, but the current fashion is to use daily compounding, which is more expensive.
Nominal and Effective APR
Credit cards advertise their nominal APR, which is the simple interest you would pay on your credit balance, in percentage terms, if compounding didn’t occur. It does not include fees. The more realistic interest cost is called the effective APR, which includes the effects of compounding and may include fees that are not paid separately. For instance, if you pay an annual fee up front, it is not included in the APR, but would be if it was paid gradually throughout the year. Late fees and over-the-limit fees are not included in effective APR since they are separately tacked on to the monthly amount due.
To see the difference between the two, consider a credit card with a nominal APR of 12.99%. If the credit card performs daily compounding, the effective APR would be 13.87%. Monthly compounding would result in a slightly lower rate, 13.79%. (Source) The differences are more pronounced for higher interest rates. For example, a 29.99% nominal APR equals a 34.96 effective APR when compounded daily, and 34.48% if compounded monthly, assuming a daily rate based upon 365 days and 12 billing cycles per year.
Calculating Your Monthly Interest Charge
Naturally, your monthly credit card bill shows your monthly interest charges. If you’d like to check the calculation, you can do the following:
1. Find the daily periodic rate (DPR) listed on the credit card statement. Note that this is your compounded effective APR divided by the number of days in the year used by the card issuer, 360 or 365.
2. Find your average daily balance that is subject to finance charges. The average account balance has been the calculated by summing each day’s account balance subject to finance charges and dividing by the number of days in the monthly billing period.
3. Calculate your monthly interest by multiplying your daily interest rate by the average daily balance and by the number of days in the period.
For example, assume your DPR is 0.04% (based on an effective APR of 14.6%), and that your average daily balance subject to finance charges (that is, a balance carried beyond the grace period) is $750. Further, assume that the card issuer uses 30-day billing cycles. The amount of interest you owe is:
$750 average daily balance * 0.0004 DPR* 30 days = $9
Avoiding interest on credit card purchases is simple, just pay off your balance every month. But what if you can’t? If that’s a chronic problem, you are spending too much relative to your income. But life is full of surprises, and you may indeed have to spread out your payments over several billing cycles. The least you can pay each month is called, not surprisingly, your minimum payment. Your credit card statement must reveal to you the minimum payment, how long it would take you to pay off your balance making minimum payments, and how much interest you would pay if you took the maximum time to pay off your balance. For example, suppose your credit card issuer requires a minimum payment equal to 4% of your balance.
From our example above, you owe $750, and you decide to stop using the card while making minimum payments until the card is paid off. Using our online credit card payment calculator, we find that your minimum monthly payment would be $30, and it would take you 54 months to repay the balance. Your total payments would be $1,739, of which $988 would be interest. Clearly, making minimum payments is extremely costly in the long run, even if you owe a modest amount.
Lowering Your APR
The most effective way of lowering your APR is to raise your FICO® credit score. Consumers with excellent credit scores pay the lowest APRs and have the highest credit limits. Check out these five tips on how to raise your credit score.
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