How is credit card interest calculated?
Learn how credit card interest is calculated and how you can avoid these charges altogether.
Contributing Writer at Tally
October 19, 2020
Credit cards can come in handy, whether you need funds in an emergency or you just want to rack up rewards. But with these benefits come responsibilities, including managing your credit card debt and understanding your interest charges.
While most cardholders recognize that credit card issuers charge interest on purchases, you might be wondering: How is credit card interest calculated? Below, you’ll learn how credit card issuers calculate and apply interest. Plus, you’ll find top tips on how to avoid paying interest altogether.
How is credit card interest calculated?
When your credit card company calculates interest charges, it uses a relatively complex equation. Here, we’ll peel back that equation’s layers to show you how this calculation works.
Converting APR to daily interest rate
Your credit card has multiple percentage-based charges. The most important one is the annual percentage rate (APR).
It's easy to lump a credit card's interest rate and APR into the same category since they're both percentages. However, they're slightly different from each other.
APR is the annualized percentage of interest your credit card charges per year. When your credit card calculates its interest rates, it does so on a daily basis. To determine your credit card interest rate, divide the APR by 365, the number of days in a year.
For example, if your credit card has a 19.9% APR, its daily interest rate would be 0.0545% (19.9% ÷ 365). This daily rate is also known as the daily periodic rate.
Determining your average daily balance
The next step in calculating credit card interest is determining your average daily balance, starting with the number of days in a billing cycle. A billing cycle can vary from one credit card to the next, but it’s generally 28-30 days. You can find the number of days in your billing cycle on your monthly credit card bill under "days in billing period" or something similar.
The credit card company determines your average daily balance by adding your total balance each day during the billing cycle, then dividing it by the number of days in the billing cycle.
For instance, if you made a $100 purchase on the first day of the billing cycle and made no other purchases throughout the billing period, your average daily balance would be $100.
If you're like many people, you use your credit card multiple times throughout the month. This consistent use makes calculating the average daily balance a bit more complicated because the credit card company must determine what your credit card balance was each day and how long it remained at that balance.
For example, if you made a weekly $50 purchase during a 28-day billing period, your total daily balance would be $350 after the first seven days ($50 x 7). It would then rise to $1,050 after 14 days ($350 + [$100 x 7]). By day 21, it would be $2,100 ($350 + $700 + [$150 x 7]). Finally, after 28 days, your daily balances would equal $3,500 ($350 + $700 + $1,050 + [$200 x 7]) at the end of the billing cycle.
Divide the $3,500 total daily balance by the 28 days in the billing cycle, and your average daily balance would be $125.
Calculating interest charges
To calculate your interest charges, multiply your average daily balance by the daily periodic rate. In our example, the credit card issuer would charge you 6.8 cents per day in interest ($125 x 0.0545%).
How much total interest your credit card company charges monthly depends on two factors: the number of days in the billing cycle and whether the credit card compounds interest monthly or daily. Compound interest is when a credit card company applies interest charges to your balance, then charges interest on the new balance. Essentially, it charges interest on top of interest.
If there were 28 days in your billing cycle, and the credit card company compounded interest monthly, the interest charges wouldn't impact your average daily balance. However, if your credit card company compounds interest daily, your average daily balance would go up slightly each day due to the interest charges, resulting in a small increase in total interest paid.
How credit card companies determine your APR
Credit card issuers determine your APR several ways, and it all starts by setting the base APR — the rate they charge only those with the best credit.
Setting the base APR
While credit card companies are free to set their base rate wherever they'd like, most tie it to the Wall Street Journal (WSJ) prime rate to remain competitive. This is the interest rate that the 30 largest banks in the U.S. charge customers with top-tier credit scores.
To determine the prime rate, the WSJ surveys 30 of the largest banks in the U.S. If 75% of the banks increase their prime rate, the WSJ prime rate will also increase. The prime rate often remains steady, but it increases and decreases along with the federal funds rate, which is the rate the Federal Reserve allows banks to charge each other for short-term loans.
Most credit card companies set their base APR at a fixed percentage over the prime rate. The number of percentage points over the prime rate is the credit card’s margin.
Since the prime rate changes periodically, most credit cards have variable APRs, meaning the APR will go up and down along with the prime rate.
Adjusting for your credit history
Like many other loans, your credit card APR is based on your credit history. If you have a favorable credit report and a good credit score, you're more likely to get a lower credit card margin, thereby getting a lower interest rate. If you have bad credit or no credit, you will get a higher credit card margin, resulting in a higher interest rate.
Applying penalty APR
Some credit card issuers also charge what's called a penalty APR. A credit card company may apply this when you break the credit card terms by either exceeding the credit limit or making a monthly payment more than 60 days late.
When a credit card company applies a penalty APR, it must notify you by mail at least 45 days before the APR increase. From then on, the credit card issuer must review your account every six months. If you rectify the cause of the penalty APR within that six months, the credit card issuer should remove the penalty APR.
A penalty APR is generally at or near 29.99% APR, according to Experian.
Can you avoid paying interest?
With an understanding of how credit card interest works, you may wonder if there's any way to avoid interest charges altogether. Here are a few options that let you use a credit card without paying interest.
Credit card grace period
A credit card grace period is the time between the end of a billing cycle and your minimum payment due date. During this time, the credit card company won't apply your interest charges to the account. If you pay off the entire balance during this period, the credit card company can't charge you interest.
Some people use this tactic to maximize the points or cash back from a rewards credit card without incurring interest charges. If you use the credit card throughout the month, you can earn rewards points. If you pay off the current balance every month, you’ll avoid all interest charges, turning a credit card into a net earner.
If you use your credit card to get a cash advance from an ATM, the grace period generally doesn't apply. Most credit cards begin charging interest on a cash advance from the day you withdraw the cash.
0% balance transfer credit card
Another way to avoid paying any amount of interest is to use a 0% balance transfer credit card. With this type of card, you can transfer your balance from another credit card and pay no interest for a fixed promotional period. The promotional period is generally 12-18 months.
While these cards charge no interest, they often charge a 3-4% balance transfer fee. So, while transferring a $1,000 balance to a 0% balance transfer card may result in no interest charges, you may incur a $30-$40 fee for making the transfer.
Remember, once the promotional period passes, you will start paying interest on the remaining balance.
Many credit cards offer deferred interest for a short period, allowing you to avoid all interest charges during that time.
Deferred interest is a common tactic for store credit cards, as they will defer interest for a specific promotional period if you spend a certain amount at a store. For example, six months deferred interest on purchases of $500 or more.
Deferred interest means the credit card company still calculates interest but won’t apply it to your account for the specified promotional period. Once the promotional period ends, it charges the amount of interest relative to the credit card’s unpaid balance. So, if you pay off half of the balance during the promotional period, the credit card company will apply half of the credit card’s deferred interest to your account when the promotion expires.
You can avoid all interest charges by paying off the total amount you charged within the promotional period.
Intro APR offers
To attract new customers, some traditional credit cards offer promotional introductory 0% APR on all credit card purchases for a specified period.
Unlike deferred interest, though, the credit card company won’t apply one large interest charge on the outstanding balance at the end of the promotional period. Instead, once the promotional period ends, the credit card company will start charging its regular APR on the balance from that point forward.
You can avoid all interest charges by paying off the entire balance within the promotional period.
Understanding and avoiding credit card interest
With all the behind-the-scenes calculations that credit card companies perform, it’s no surprise you might ask yourself how credit card interest is calculated. Credit card interest calculations involve pulling together various parts, including:
Daily periodic rate
Number of days in a billing cycle
Average daily balance
With these components combined, your credit card company determines how much interest to charge you. Still, you can avoid paying any interest with a few tactics like using your credit card grace period, opting for a 0% balance transfer card or using a credit card with a promotional APR.