If you don’t know how credit card interest works, then you won’t be able to maximize the benefits of your credit card.
Credit Card Interest is one of those things that affect us all (unless your name is Dave Ramsey). But not everyone understands exactly how it works.
In this article, we will explain how Credit Card Interest works. By the end of this article you will understand:
Why it’s important to learn about Credit Card Interest.
How to calculate it.
When you have to pay off your credit card interest.
A few strategies to deal with credit card interest
Why is it important to understand how Credit Card Interest works?
There are so many different credit cards out there, and they all offer different benefits.
Understanding credit card interest will help you make smart decisions when you are shopping for different credit cards. If you’ve done any research, or have any experience with credit cards, you probably know that different credit cards offer different Annual Percentage Rates (APR).
Your annual percentage rate is what you will use to calculate your interest for the month if you aren’t able to pay your balance in full.
Depending on your credit card, your APR can range anywhere from about 10% - 24.99%.
Some credit cards even offer 0% APR for a fixed amount of time as an incentive to sign up with them.
If you understand how credit card interest works, you will be able to plan ahead and manage your finances more effectively.
How to Calculate Credit Card Interest
Calculating Credit Card Interest is actually not a walk in the park. It’s more than just multiplying your interest rate to your total balance.
Credit Card Interest is calculated by multiplying your average daily usage by your daily interest rate.
So, calculating your credit card interest can be broken down into 3 steps.
Step 1: Find your daily interest rate
The very first step in finding your daily interest rate is to find your Annual Percentage Rate (APR) that your credit card issues you. This can be found on your balance statement.
Let’s say Jimmy doesn’t always pay off his credit card balance and he wants to figure out how his interest rate is affecting him. Jimmy looks at his balance statement and sees that he has a 14% APR.
To find Jimmy’s daily interest rate, we would simply divide his APR of 14% by 365 (days in the year):
14 / 365 = 0.038
Then multiply this number of days in the month - Let's use August as an example which has 31 days.
31 X 0.038 = 1.14%
So, Jimmy’s Daily Interest Rate ( also known as Daily Periodic Rate or DPR) is 1.14%
Step 2: Find your daily usage
Let’s say Jimmy didn’t pay off his full balance last month and his current balance is $500 for the month of August.
For the rest of August, Jimmy’s credit card activity looks like this:
On August 1st, Jimmy starts with a balance of $500.
On August 10th, he pays off $200 of his balance - Jimmy’s balance = $300 (500-200)
On August 15th, He makes a purchase of $50 - Jimmy’s balance = $350 (300+50)
On August 21, he makes another purchase of $25 - Jimmy’s Balance = $375 (350+25)
Then Jimmy goes through the rest of August with a $375 balance because he isn’t able to pay it off...
To find his average daily balance, Jimmy will have to find his average usage of each day of the month and divide it by 31 (the number of days in August)
Jimmy’s math should look something like this:
August 1 - 10 : $500 x 10 days = $5,000
August 10 - 15 : $300 x 5 days = $1,500
August 15 - 21 : $350 x 6 days = $2,100
August 21 - 31 : $375 x 10 days = $3,750
$12,350 / 31 days = $398.39
Jimmy’s average daily balance for the month of August was $398.39
Step 3: Multiply your daily interest rate by your daily usage
At this point, Jimmy has everything he needs to calculate his interest for the month.
Now, let’s take Jimmy’s daily interest rate and multiply it by his average daily balance for the month:
1.14% (or .0114) X $398.39 = $4.54
So, Jimmy will have to pay an extra $4.54 in addition to his current balance.
When do you pay interest on a credit card?
In our Jimmy example, he will incur the fee of $4.54 on his next billing cycle because he didn’t pay off his remaining balance for the month of August. So, Jimmy will start the month of September with his revolving balance plus $4.54.
How to pay less in Credit Card Interest
I think we can all agree the math we did for Jimmy wasn’t a simple walk in the park. If you want to make life easier on yourself, the best thing to do is pay off your full balance every billing cycle.
If you can’t pay your full balance, then you can pay as much as you can so you don’t incur a higher interest fee for the month.
You can pay your balance at an earlier date in the month or begin to make payments earlier in the month so your average daily balance is reduced.
Other factors to keep in mind
How interest is determined: Credit Card companies may decide your interest rate based on your credit history. Generally, if you have a history of good credit, then you will be offered a lower interest rate. So, if you have a history of poor credit, then your rates are likely to be higher.
Other types of interest: Remember that interest isn’t only applied to purchases. Interest can also be charged on cash advances and balance transfers. These may even come with different interest rates or additional fees. You can look for your terms and conditions with your credit card to know what exactly to expect.
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