How is your credit card interest calculated? – Forbes Advisor

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When your monthly credit card statement arrives, you have two choices: pay the bill in full by the due date or settle it over time. The latter choice will give you more time to settle a balance, but it will add interest charges, based on the annual percentage rate (APR), on top of what you already owe.

Here’s what you need to know about how these interest charges are calculated.

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What is my interest rate?

Your interest rate on a credit card is usually expressed as an annual percentage rate (APR) and reflects the amount of interest you’ll pay on your card when you carry a balance. You can find your credit card’s interest rate in the terms and conditions you’ll receive once you’ve approved a new card, on your monthly credit statement, or by calling the number on the back of your card and asking.

Variable interest or fixed interest

Most, but not all, credit cards charge a variable APR range based on an index rate. This means that the rate offered to you is not static or fixed, and will adjust in tandem with a reference rate, usually the Federal Reserve’s prime rate. This rate is used as a benchmark for many types of loans, including credit cards, car loans and mortgages, and may fluctuate depending on economic conditions and any decision by the Fed to change it.

What is an APR?

The APR is the annualized interest rate you would pay over the course of a year on any balance For example, if you have a balance of $10,000 on a credit card with an APR of 17% and you leave it intact for an entire year, you’ll accumulate $1,700 in interest.

When you Apply for a credit card, several factors go into determining the APR you will receive. Most cards offer an APR range, which is specified in the card’s terms and conditions. For example, if the range of a card you are interested in is 15.99% to 22.99%, those with the the best credit ratings are likely to qualify for the lowest rates in this range.

Those with thin credit records or less than stellar credit may not even qualify for a number of credit cards and may instead need to consider cards aimed at those with fair credit scores. These cards typically come with higher APRs because banks consider these applicants to be at higher risk of default.

APR vs interest rate

When it comes to credit cards, APR and interest rate are interchangeable terms. For mortgages and other types of loans, the APR is often the interest rate plus any other fees that apply. But credit cards do not generate any other cost in the APR. Fees such as annual fees, balance transfer fees or foreign transaction fees are treated as separate and distinct fees.

How does your credit card work?

Most credit cards calculate your interest charges using the average daily balance method, which means your interest is compounded and accrued each day, based on a daily rate. In other words, each day your finance charges are based on the previous day’s balance.

How to Calculate Credit Card Interest

1. Convert the annual rate to a daily rate

The daily rate is determined by dividing your credit card’s APR by 365 to find the daily rate. So, for a credit card with an APR of 17%, the rate per day would be 0.17/365, or 0.000466%.

This daily interest rate is then multiplied by your balance on that day. Since the average daily balance is compounded each day, the calculation is based on the previous day.

For example, if you have a balance of $10,000 on day 1 of your billing cycle, on day 2 your card would have a balance of $10,004.66, which is what you get when you multiply the balance of $10,000 by the daily rate of 0.000466.

This means that the balance of $10,004.66 on day 2 would also be subject to the daily rate of 0.0466%, which would bring your balance to $10,009.32 on day 3 and so on until the end of the day. billing cycle for that month.

2. Determine your average daily balance

Your average daily balance is based on your balance for each day of that month’s cycle. Your credit card statement won’t show your balance amount for each day, but you can calculate it based on your transactions that month. For example, on day 1 of a 30-day billing cycle, you had a balance of $0, then you didn’t charge $500 until day 5. On day 10, you made another charge of $100. Your daily balance for each day would be as follows:

  • Days 1-4: $0 balance
  • Days 5-9: $500 balance (reflects purchase of $500)
  • Days 10-30: $600 balance (includes $100 surcharge)

To find the average daily balance, you need to add the balance from days 1 to 30 and divide it by the number of days in the billing cycle, which is 30 in this case.

So your calculation would look like this:

  • (Day 1 Balance + Day 2 Balance + Day 3 Balance + Day 4 Balance etc…) / Number of days in billing cycle

Using the example above, this would look like:

  • (($0 x 4 days)+($500 x 5 days)+($600 x 21 days)) / 30 = $503.33 average daily balance that month

3. Calculate your interest charges

The last step is to calculate the amount of interest you will pay. This is based on the average daily balance, your daily recurring rate, and the number of days in the billing cycle.

So using the examples above it would look like:

  • $503.33 x 0.000466 x 30 = $7.04 (the amount of interest you will pay that month)

It may not be an insurmountable amount of interest for a month, but make no mistake about it. If you let a balance build up or just make the minimum payments each month, it can cost you dearly over time. If you do this same calculation using an average daily balance of $10,000, for example, you will accrue $139.80 in interest for that month alone.

Accumulated finance charges explain why cards with 0% APR offers can be so appealing to someone who needs more time to pay their bill. If you have a balance of $10,000 on a card with a 12-month 0% APR offer and you don’t make any payments for a year, you’ll owe that same $10,000 without racking up a year of finance charges on top of your existing debt.

But, if you plan to transfer a balance to a card with a promotional 0% APR on balance transfers, be aware that these cards often carry a balance transfer fee. It pays to weigh the pros and cons before transferring a balance.

Do credit card issuers determine interest rates?

Most credit card issuers charge a varying APR range based on an indexing rate. This means that the rate offered to you is not static or fixed, and will adjust in tandem with a reference rate, usually the Federal Reserve’s prime rate. This rate is used as a benchmark for many types of loans, including credit cards, car loans and mortgages, and may fluctuate depending on economic conditions and any decision by the Fed to change it.

When you receive an APR on your credit card of, say, 17%, the issuer bases that number on the prime rate plus whatever additional percentage it chooses to add to it. The difference between the prime rate and what banks add is called a spread, and it’s one of the ways banks profit from credit cards.

How to Lower a Credit Card Interest Rate

You can try to contact your issuer and ask them to lower your rate. If your payment history has always been on time, they may be able to lower your APR by a percentage point or two.

If they can’t or won’t offer you a lower rate, it might be a good idea to focus on improve your credit score so you will be entitled to better rates. Among other things, you can ensure that you make your payments on time and reduce your overall credit usage by not carrying too high a balance on your card.

If the card issuer still refuses to lower your rate, you might consider a card with a 0% APR Balance Transfer Offerespecially if the current rate after the promotional period is lower than that of your current credit card.

There’s another way to avoid paying interest: by paying off your balance in full each month, if possible.

When is the best time to pay?

By law, credit card issuers grant Grace period at least 21 days before your due date to pay off your balance without accumulating interest or other penalties for new purchases. This means that no matter what you owe at the end of your billing cycle, as long as you pay that balance in full and within the grace period, you won’t have to pay interest. If you only pay part of the bill, you will be charged interest on the remaining amount, called the revolving balance.
If you pay your credit card bill early in the billing cycle, the lower balance will be reported to the credit bureaus, which can positively impact your overall credit score.

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Conclusion

A number of factors go into determining how much interest you’ll be charged on your credit card. Your card’s APR, your average daily balance, and the number of days in the billing cycle are all part of the calculation. It may be possible to reduce finance charges by requesting a lower APR from your credit card issuer, moving your balance to a card with a 0% APR offer or a lower offer than your current card, or paying your balance in full each month.

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