If you’ve ever looked at your credit card bill and wondered what all the numbers on your statement mean and how the amount you owe was calculated, read on as we explain how credit card companies calculate interest.
Credit card interest explained
Although credit card companies usually advertise their interest rates as the annual percentage rate (APR), this is actually misleading. While this percentage gives you an idea of how much interest you’ll pay over time, it’s not completely accurate.
This probably comes as no surprise, but credit card companies don’t charge you interest once a year. They actually charge you interest every day that you carry a balance. This rate is known as the daily periodic rate (DPR), which can also be called a periodic interest rate or a daily finance charge rate.
If your credit card statement doesn’t include the DPR, you can figure it out yourself. Do this by dividing your APR by the number of days in the year. (Be aware that some banks use 360 days, while others use 365).
For an APR of 13%, divide the 13% by 365. You will come up with 0.036% DPR per day. This may not seem like much, but it adds up over time.
To figure out how much interest you owe in a month on an unpaid credit card balance, the credit card company uses your average daily balance. This amount is averaged, because credit card balances tend to fluctuate over the month as you buy more items and make payments.
Here’s an example of how the average daily balance is calculated:
You owe $250 at the beginning of the month, and on the 15th of the month you charge another $250. At the end of the 30-day billing cycle, the credit card company determines your average daily balance by multiplying each balance by the number of days in the month that you had that balance. Then those figures are added together and the total is divided by the number of days in the month to get the amount you owe in interest.
$250 beginning of the month to mid-month x 15 (days) = $3,750
$500 mid-month to end of the month x 15 (days) = $7,500
$3750 + $7,500 = $11,250, divided by 30 days = $375 average daily balance.
The $375 average daily balance is then multiplied by your DPR (0.036%), which would be 0.135. That figure is then multiplied by the days in the month and you get interest owed. So when you multiply 0.135 by 30, you get $4.05, which is the interest charged that month on the $375 average daily balance.
If you plan on making a payment to your credit card payment, keep in mind that it will save you money to pay the amount at the beginning of the month rather than at the end.
Multiple interest rates
If you have different interest rates on your credit card, that makes things even more complicated. This usually occurs when you have an interest rate for purchases and another for cash advances. If you have more than one interest rate, each is determined separately and then added together to get the amount you owe in interest.
How do lenders determine credit card interest?
Of course, you want to owe the least amount of interest possible. Your best option is to choose a card with a low APR, or even better, a card that offers 0% APR for a promotional period, which is usually six to 18 months.
To qualify for such cards, you must have good to excellent credit (700+) and a track record of paying your bills on time. If you’re unsure what your credit score is, check it here. If your score is fair or low, you’ll probably be offered a higher interest rate card.
To qualify for better interest rates, improve your credit score by paying off debt, paying your bills on time and dealing with inaccuracies on your credit report. Even a few points higher on your score can lead to better credit card interest rates.
Credit card interest rate calculations can be complicated, but what doesn’t have to be difficult is choosing a credit card. Check out SuperMoney’s personal credit card reviews page for some credit card options.