How to Calculate Credit Card Interest
Don’t be bullied by credit card debt. Learn how to calculate credit card interest and begin working the numbers to your advantage. Get Interested in Your Monthly Credit Card Interest!
When the monthly credit card statement rolls in, many of us pay the minimum payment amount due without even glancing at how much interest was charged. Likewise, those who manage to pay more than the minimum amount rarely take the time to study the fine print. This can cost you a lot of extra fees, especially when taking a credit card cash advance. Read more on how to get cash from a credit card to find out if getting the money is right for you or not.
It’s a frightening thought considering that American consumers owe $11.9 trillion in debt with $884.8 billion attributed to credit cards. The same report from American Household Credit Card Debt Statistics also indicates that the average household credit card debt is $15,609.
You should control your credit. Your credit shouldn’t control you.
No matter where you fall within the debt spectrum, whether you owe a little or a lot, you DO owe it to yourself to make solid, well-informed decisions when it comes to your financial life. Granted, that’s not always easy. However, you can remove some of the underlying anxiety by demystifying credit card interest. One of the first things you must do to get a handle on your credit card debt is to understand it. This holds true especially if money is tight, and you’re struggling to make ends meet.
What Is Credit Card Interest?
Credit card interest is basically a fee you pay for borrowing money. Borrowing money via a credit card is considered revolving debt. It’s easy to forget that purchasing goods and services with your credit card is like taking out a loan. One reason for that is because there is not an application process each time you want to increase the amount. That is of course unless you have reached your agreed credit limit.
Lenders are typically banks, credit unions, or private companies and these lenders must generate revenue as a function of profitability. In other words, they want to make money. One way they do this is by charging interest. One such companies is Elan Finanacial Services. For more on their credit card check out our review on the Elan credit card.
How Is Credit Card Interest Calculated: Is There a Simple Formula?
There is a formula for calculating credit card interest and it actually is simple. It’s just not straightforward. Have a look and then let’s go through it step-by-step. It will become clear what that means.
The formula for determining credit card interest is:
Average Daily Balance x Periodic Interest Rate x Number of Days in the Month = Amount of Credit Card Interest
How Do I Get the Information Needed to Calculate Credit Card Interest?
In order to calculate credit card interest you need three key pieces of information.
- Annual Percentage Rate (APR) – This rate is stipulated in the agreement with your lender. It may be a fixed rate or a variable rate. However, be careful because a fixed rate doesn’t mean that the rate can never be changed. There are several things that affect your annual percentage rate, including your credit score, the type of credit card, and the type of lender.
Imagine, for the sake of this example, that your APR is 15%.
- Daily Periodic Rate – The Daily Periodic Rate is determined by dividing the APR by either 360 or 365 depending on your bank or lender. Why, you might be wondering, would there be a difference in the way lenders calculate the length of a year?
- Using 365 is considered the full-year method.
- Using 360 is considered the banker’s year method.
Dr. Timothy R Mayes, Professor of Finance at Metropolitan State University of Denver, notes that this differentiation goes back to days of old, before calculators and computers, when working on 12 months x 30 days = 360 made calculations easier to do by hand.
Your APR is 15%, and we’ll use the full-year method.
15 ÷ 365 = 0.041
Your Daily Periodic Rate is 0.041.
- Average Daily Balance – When your lender assigned an Annual Percentage Rate to your card, it would have been an honest mistake to assume that it meant interest would be charged at that percentage at the end of the year; annual meaning yearly. Wouldn’t that make it a whole lot easier?
In reality, what happens is that interest accrues on the amount owed every day that you do not pay. Your Average Daily Balance is the average amount of the balance over the month.
Imagine that you have a credit card balance of $1,000. Let’s say that your lender charges an Annual Percentage Rate (APR) of 15%.
You make a $200 payment on the 11th day of the month and on the 21st day of the month, you make an additional payment of $300.
Your Average Daily Balance is calculated as follows:
(10 x $1000 + 10 x 800 + 10 x 500) ÷ 30 = 767
Your Average Daily Balance is $767
After You Calculate Interest Rate:
Last credit card statement balance was $1,000
Periodic Interest Rate – 0.041
Average Daily Balance – 767
Here is our formula again:
Average Daily Balance x Periodic Interest Rate x Number of Days in Month = Amount of Interest Charged
767 x 0.041 x 30 ÷ 100 = $9.43
One Major Problem With Revolving Debt is Compounded Interest
As you just learned, credit card interest is accrued daily, not yearly. One element of concern is Compounded Interest, which means that the Daily Interest is added to the Principal which carries over to the next day, essentially creating a new Principal.
Considering the earlier statistic that the average American household carries $15,609 in credit card debt, let’s generalize and apply a flat 18% APR to that number in order to determine the Periodic Interest Rate.
18% ÷ 365 = 0.049 Periodic Interest Rate
Credit card balance on the first day $15,609
Amount interest charged on the first day – $7.65.
Credit card balance on the second day $15,616
Amount of interest charged on the second day – $7.65
Credit card balance on the third day $15,623… and so on.
Congratulations! You’ve made it through one of the most frustrating aspects of financial number crunching. It’s no wonder that most people ignore their credit card interest. However, now you don’t have to ignore a potential problem. You can take this information and plan your payments strategically. Pay more and often to avoid undesirable compounded interest.
Use this information to reduce your revolving debt quicker and in turn that will correspondingly increase your credit rating. Using credit cards as a short-term financial option isn’t always a bad decision. Just remember that, while it is easy to spend, spend, spend – it’s not so easy to pay it back.