Credit card interest can be confusing, even for those who have been using credit cards for decades. Sure, it’s buried in the fine print how credit card interest is calculated, but deciphering that legal mumbo jumbo is no easy task! So here’s a straightforward guide to help you.
How do credit cards calculate interest?
In the United States the vast majority of credit cards use the daily balance method – that means interest is calculated each day you carry a balance.
1. The daily rate is calculated
If your APR was 15% then your daily balance would be calculated as follows:
15% divided by 365 days = 0.0411%
So you would be charged 0.0411% each day a given amount is carried as a balance
2. Interest is compounded for each day
The APR advertised on credit cards is usually what is called the nominal rate (the rate before taking into account the compounding). Your effective interest rate will be higher because of daily compounding – each day your interest is calculated and added to your balance. That means the following day’s balance will be slightly higher (and therefore cost slightly more in interest).
But to what degree will daily compounding affect how credit card interest is calculated? Well, going back to the example above, the nominal 15% APR would actually turn into an effective interest rate of 16.18% if interest was compounded daily.
Of course payments, credits, and new charges will also be taken into account when calculating the applicable interest for each day.
3. The daily interest charges are added up
The credit card interest is calculated for an entire billing cycle by adding up all the daily interest charges during that period.
Using the above example, the nominal monthly APR would be 1.25% (15% divided by 12 months) and the effective APR would be 1.258% if compounded daily.
Now you know how credit card interest works! However, there is something very important you may not know…
There is no grace period if you don’t pay your charges in full!
Many people assume if you don’t pay your balance in full, interest will only start accruing after the grace period. Unfortunately that’s not how it works.
Basically, everyone is charged interest from the date of purchase on their credit cards. However if you pay off your bill in full before the grace period, those interest charges are waived and you don’t pay them (nor will you ever see them on your statement).
However if you do carry a balance forward, those interest charges going back to the date of purchase will show up on the following month’s bill. This is why many are shell shocked when they see their interest charges for what they thought was just one month.