How Is Credit Card Interest Calculated?
Credit card interest rates are set even higher than home or car loan interest. This is because the use of a credit card is considered unsecured debt, which is why credit cardholders are charged so much on the interest rate. For many cardholders, their credit card is used almost every day for minor purchases like groceries, which starts to accrue interest for each purchase immediately. How are some cardholders avoiding paying their interest charges while others are struggling with the major addition to their monthly bills? Let’s take a look at how credit card interest is calculated.
The basics of calculating credit card interest
In order to reduce their credit card interest charges, a cardholder should first understand how it is calculated. The key factor of credit card interest is that the charges are based on the cardholder’s average daily balance. At the end of every billing period, the cardholder’s total unpaid balances at the end of each day are added up and then divided by the number of days in the statement cycle to find the average daily balance. Therefore, if you use your credit card for a large transaction early in the billing cycle (usually a month), your average daily balance will be higher than if you save the large transactions for the end of your billing cycle.
Your credit card purchases are subject to a standard interest rate called the Annual Percentage Rate, or APR. This number will vary between different cards and different people, depending on factors such as credit scores. To convert this yearly rate to a daily or other periodic rate, divide it by 365, the number of days in the year. This should result in a tiny number, which should then be multiplied by both the average daily balance and the number of days in the periodic cycle. The total of this is equal to the interest owed by the cardholder.
While the number calculated above doesn’t look too severe on the surface, the interest is still compounded. Many credit card providers add interest charges to the daily balance once every month, while others add the interest every day immediately after the transaction took place. If compounded daily, the effective interest rate based on the Annual Percentage Rate becomes higher.
How to reduce your credit card interest rate charges
Most credit card providers offer a “grace period” between the end of the statement cycle and the payment due date. If the cardholder pays their entire statement balance in full during this time, most providers will waive the interest charges as a reward. However, if the cardholder fails to pay their entire balance or to make the payment on time, they will lose their grace period.
The only way to completely avoid credit card interest charges is to take full advantage of the grace period by paying every statement balance in full and on time. Cardholders can also minimize their interest charges when they can’t avoid them altogether by reducing their average daily balance as much as possible. An effective strategy for both options is to pay the balance in installments throughout the cycle instead of waiting for the due date.
For more information about how credit card interest is calculated, or to sign up for a merchant account, please call (888) 924-2743 or go to Charge.com.