How Does Credit Card Interest Work?
Everyone knows that credit cards charge interest when you don’t pay off what you spend in a given month, but the question of how banks calculate interest is something that still baffles many folks, and understandably so.
Credit card billing practices are complicated, and their nuances are enough to give most people a major headache. Let’s see what we can do to change that.
Every credit card – save for charge cards – has an Annual Percentage Rate (APR). An APR technically isn’t the same thing as an interest rate, but they are closely related.
To calculate the interest you’ll be charged on a daily basis when revolving a balance, simply divide your APR by 365 and voilà, you’ve got it. In other words, if your APR is 15%, you’ll be charged interest on your outstanding balance at a daily rate of 0.041%. Your outstanding balance includes any interest that was previously assessed. That means you pay interest today on not only your principal balance, but also the interest you were assessed yesterday, the day before that, etc.
Finance charges are therefore applied to your average daily balance over the course of a billing period. In other words, if you have an existing balance and continue to make purchases throughout the month, the amount that incurs finances charges will be greater than the original balance held at the beginning of the billing period.
Banks will not charge you interest if you do not carry a balance from month to month, otherwise known as a revolving balance. You don’t have a revolving balance if you have paid the full amount printed on your last two bills by the due date.
In other words, when you have satisfied the above requirement, most credit card companies will offer a no-interest grace period of around 25 days from the date your bill becomes available to when you need to submit payment.
We often receive questions from bewildered consumers who receive a bill that includes finance charges after they’ve brought their account balance to zero. They typically assume (or simply hope) that their credit card company has made a mistake that can easily be corrected without them having to pay any more money.
While that might end up being the case in certain situations, the confusion is most often a result of misunderstanding the credit card billing process as well as how finance charges are calculated and ultimately assessed.
So, let’s see what we can do to set the record straight, starting with a practical example.
Say that you didn’t pay your last month’s bill in full and you owe $500 when your next month’s credit card statement becomes available on June 1st. While you may have until June 30th, for example, to submit a payment before it’s considered late, interest will be assessed based on the average daily balance in the interim. In other words, the amount that you owe will increase with each passing day.
So, even if you pay off the full $500 balance by the due date (June 30th in this example), you’ll still owe money for the daily finance charges that this $500 balance incurred since June 1st. As a result, when your new bill becomes available on July 1st, your balance will be equal to the finance charges incurred the previous month. If you do not pay this amount, you will incur interest on interest and will continue to do so until you have paid two consecutive bills in full and therefore regain your grace period.
What can you take away from this example?
- If you begin a billing period with a revolving balance, interest will accrue on a daily basis.
- Paying off your original balance won’t bring your total account balance to zero, as you will be responsible for the finance charges that accrued from the time your bill was made available to when your payment arrived.
The perhaps confusing distinction between your original balance and the finance charges that accrue on top of it underscores the importance of carefully reviewing your monthly credit card statements. Doing so, rather than simply taking a quick glance or throwing the statement in the trash sight unseen will enable you to spot unanticipated charges as well as raise questions about potential mistakes.
As mentioned at the outset of this article, it is possible for a credit card company to misstate a charge or balance on your account. But if you don’t notice it and therefore sound the alarm, then you’ll likely end up paying it in error or have interest accrue and the situation grow more complicated over time.
Paying off what you spend using a credit card every month is obviously the best way to avoid being charged interest, but it’s not the only one. There are also a few tricks you can use to ensure that finance charges won’t show up on your account. We’ll explain them below.
- Every Day Counts: Interest gets assessed daily, so waiting for your due date when revolving a balance will results in 30 days of new finance charges that you’re responsible. In other words, if you want to curtail interest when carrying a balance, pay your bill on the same day your bill becomes available.
- Leverage a 0% credit card: Certain credit cards waive interest rates for the first 6-24 months in order to help consumers either finance big-ticket purchases or transfer an existing balance. In most cases, regular interest rates will apply to whatever balance remains at the end of the 0% intro period. However, some merchant-affiliated credit cards offer “deferred interest,” which means that if you fail to pay down your full balance by the end of the 0% term, regular rates will retroactively apply to your entire original purchase amount. Avoid deferred interest payment plans at all costs.
- Use a credit card calculator: Maximizing the value of any 0% credit card necessitates having a strategic debt payment plan. A credit card calculator can help you determine how much you’ll need to pay each month in order to be debt-free by the time high rates kick in.
- Use the Island Approach: Separating your ongoing purchases from your revolving debt will ensure that interest rates apply to the lowest possible amount. Given that you should always be able to pay for everyday expenses like gas and groceries in full every month, isolating such expenses on one credit will prevent the average daily balance on your card designated for debt from being unnecessarily high. This, in turn, will lower your overall interest charges.
- Ask for a Lower Limit: If you continually spend more with a credit card than you can afford to pay back, you might want to consider asking your issuer for a lower limit in order to remove temptation entirely.
While understanding how banks calculate interest can be helpful, it’s not a prerequisite to understanding that debt can be detrimental to your finances. Not only is interest expensive, but it can quickly become unmanageable, causing you to miss payments and incur credit score damage.
Keeping a budget, regularly reviewing your spending habits, and avoiding unnecessary debt are therefore essential to responsible money management.
Still, if we as a society are going to make true strides, we must seriously address our financial literacy (or lack thereof). This applies to the way in which interest is calculated, across the breadth of personal finance, and involves everyone from parents to the financial service providers themselves. “Schools should also offer basic practical education,” says Randall Bartlett, a professor of economics at Smith College. “The power of compounding is most important for the young to understand....and most don't ever figure it out...out do when they are 55 and it is too late.”
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