Take a look at your most recent credit card statement. Right below the lines for “balance,” “minimum payment due,” and “payment due date,” you’ll find the Minimum Payment Warning, which reads something like this: “If you make only the minimum payment, you will pay more in interest, and it will take you longer to pay off your balance.”
Below the Minimum Payment Warning, you’ll see a 3 x 2 table that reveals the time needed to pay off your balance in full under two payment scenarios: one in which you make only the required minimum payment each month, and one in which you make a slightly higher monthly payment. Both scenarios assume you don’t make any further charges.
Before I sat down to write this article, I looked at a recent credit card bill of my own. With a period-ending balance of $1,141.34 and a minimum payment of $25, my Minimum Payment Warning indicated I’d need about six years and $1,806 to pay off my balance on the minimum payment alone. Were I to add $15 to my monthly payment, I’d need just three years and $1,457 to pay off the balance, for a total savings of $349.
That a relatively minor tweak produces such significant savings underscores the importance of paying more than the minimum each month. After all, if we look hard enough, most of us can find $15 extra in our monthly budgets.
It also underscores the power of compound interest. And it begs the question: How much does the average consumer really know about how credit card finance charges are calculated?
The answer to that question is below. But first, the requisite disclaimer: Under normal circumstances, you should always strive to pay off your credit card balances in full by your monthly statement due date each billing cycle, thereby avoiding interest charges (and true credit card debt) altogether. An inability to do so may indicate that you’re spending more than you earn, which is detrimental to your long-term financial health.
Calculating Your Credit Card Interest
Your credit card account’s cardholder agreement should spell out the method by which your credit card issuer calculates your finance charges. The three common methods include daily balance, average daily balance, and adjusted balance (more on those in a moment).
Finding Your Daily APR
No matter how your finance charges are calculated, you can always find your card’s effective daily finance rate (the annual percentage rate, or APR) by performing a simple calculation:
APR / 365 = Daily APR
For example, the daily finance rate for purchases on a card whose regular purchase APR is 17.99% is: (0.1799 / 365) = 0.00049287671, or 0.000493 rounding up.
When you have multiple balances subject to different APRs – say, one balance subject to the regular purchase APR and another subject to the cash advance APR – then you’ll need to calculate daily APR separately for each.
Credit card issuers use daily APR in all three balance calculation methods.
Interest Calculation Methods
Your credit card issuer likely uses one or more of these methods to calculate your interest:
1. Daily Balance Method
The daily balance method uses the daily APR to calculate interest on every day-ending balance, resulting in 30 or 31 distinct interest calculations each month for most statement periods. When interest compounds daily, the issuer adds the daily interest charge to the next-day balance before calculating interest for that day.
For example, if your balance is $1,000 on the first day of the statement period and your daily APR is 0.000493, your daily interest charge is $0.49. That charge is then added to your balance, raising it to $1,000.49 on the second of the month, absent new purchases. Your daily interest charge on the second day of the statement period is calculated on this new balance. This cycle repeats every day of the period, at the end of which you’ll have accrued $15.10 in interest charges, absent new purchases.
When interest compounds monthly, the issuer performs just one official interest calculation per month, adding the sum of your daily interest charges to your balance on the last day of the statement period and then calculating interest on the entire new balance. On a beginning-period balance of $1,000 at a daily APR of 0.000493, monthly compounding produces $14.99 in interest charges – a small but meaningful discount to daily compounding.
Refer to your cardholder agreement to determine whether your issuer compounds interest daily or monthly.
2. Average Daily Balance Method
The average daily balance method takes the average of your daily balances over the entire statement period, multiplies that average by your daily APR, and then multiplies the product of that calculation by the number of days in the period.
Here’s a simplified example. If your average daily balance during a 30-day statement period is $1,000 and your daily APR is 0.000493, the calculation is:
1,000 * 0.000493 = 0.493 * 30 = 14.79
As you can see, the average daily balance method results in slightly less interest than the daily balance method at either compounding frequency.
3. Adjusted Balance Method
The adjusted balance method calculates interest at the end of the period on the difference of your period-beginning balance and payments made during the period. In order to perform this calculation, the issuer multiplies the difference by the monthly APR – in other words, the product of the daily APR and the number of days in the period, or the yearly APR divided by 12.
For instance, if the daily APR is 0.000493 and the statement period has 30 days, the monthly APR is 0.01479. If you begin the period with a $1,000 balance and make no payments in the subsequent 30 days, your interest for the period is:
1,000 * 0.01479 = 14.79
In other words, it’s the same as with an average daily balance of $1,000 using the average daily balance method. But, more likely, you’re going to make a payment during the statement period. Let’s say you put $500 toward your balance at some point during the month. The calculation becomes:
(1,000 – 500) * 0.01479 = 7.395 = 7.40
Simply by paying off half your balance at some point during the period, you slash the month’s interest charge in half. For interest calculation purposes, the paid-off balance doesn’t exist.
The benefit of the adjusted balance method – and the reason it’s not used as widely as the other two methods – is its de facto extension of the grace period. As long as you pay off your past-grace balance in full at some point during a statement period, you’ll pay no interest on that balance during that period. Even if you don’t pay off your balance in full, you’ll only pay interest on the portion of your period-beginning balance not paid off by the end of the month, no matter when you make the payment.
Minimizing Residual Interest
“Residual interest” describes interest accrued in a statement period ending with a zero balance. In other words, if you begin the period with a $1,000 balance and make a $1,000 payment at some point during the period, you’ll end the period with no balance – but you may still see an interest charge on your next statement.
Only the adjusted balance method allows a cardholder who carries a balance beyond the end of their grace period to completely avoid residual interest. If your issuer uses either the daily balance or average daily balance method to calculate interest, you’ll be on the hook for some residual interest in any statement period during which you carry a post-grace balance. How much residual interest you’ll accrue depends on your payment timing. Moving up your payment date reduces the number of balance days in your interest calculation, thereby reducing total interest charges.
For example, using the daily balance method with daily compounding on a period-beginning balance of $1,000, you’ll accrue about $0.49 in interest every day you carry a balance with no payments or purchases. Pay your balance on the first day of the period, and you’ll get away with just $0.49 in charges; wait until the last day of the period, and you’ll pay an interest premium of $14.61.
Factors That May Affect Your Credit Card Interest Rate
How your credit card issuer calculates finance charges matters to your long-term balance-carrying costs, but your effective interest rate is far more consequential. These are among the most common factors that could temporarily or permanently affect that rate.
1. Transaction Type
Absent low-APR introductory promotions that may apply only to one or the other, purchases and balance transfers usually accrue interest at the same rate.
Cash advances are more likely to accrue interest at different, often higher rates. Some issuers set multiple cash advance rates, depending on the method used – ATM cash advances, in-branch cash advances, and so on. Cash advance balances generally aren’t subject to the legally required grace period for purchases, so they begin accruing interest as soon as they post to your account.
Bear in mind that most issuers add balance transfer and cash advance fees to transaction balances, further increasing their cost. Fees typically range from 3% to 5% of the transaction amount. Issuers usually apply payments above the required monthly minimum to higher-interest balances first.
2. Low-APR Introductory Promotions
Credit card issuers frequently use low or 0% APR introductory promotions to entice applicants. These promotions most often apply to purchases and balance transfers. During the promotion period, balances covered by the promotions accrue interest at the lower rate – or don’t accrue interest at all, in the case of 0% APR promotions.
However, some issuers charge interest retroactively on balances not paid off by the end of the promotional period. If you’re not sure you can pay off your balance in full by the end of the promotional period, think carefully before moving forward.
Also, carrying a transferred balance past your statement due date may eliminate your card’s built-in grace period for purchases, even if you plan to pay off any purchases before they’d normally begin accruing interest. If your card offers a promotional rate on balance transfers only, the only way to avoid interest on purchases is to refrain from carrying an outstanding balance on purchases until your balance transfer balance is paid off in full.
3. A Change in Your Credit Score
A material change in your credit score may prompt your issuer to increase your APR on new balances – one of several drawbacks of a bad credit score. By law, your issuer must notify you at least 45 days in advance of the change, and you technically have the option to opt out of the increase. However, if you do opt out, your issuer will almost certainly close your account.
The good news is that issuers are prohibited by law from retroactively increasing interest rates on existing unpaid balances, so you won’t be blindsided by higher-than-expected interest on previous charges.
Pro tip: If you’ve noticed a drop in your credit score, sign up for Experian Boost. With Experian Boost, you’ll receive credit for on-time phone, utility, and Netflix payments.
4. Late or Missed Payments
If you fail to make at least the minimum payment by your statement due date, your issuer may add a late fee to your balance. After the second late or missed payment, your issuer may impose penalty interest at a substantially higher rate than normal – 29.99% APR or higher is common. Once imposed, the penalty APR may remain in force indefinitely; check your cardholder agreement for details.
5. A Change in the Prime Rate
Most credit card APRs are variable. That means they’re subject to change with the prime rate, a popular interest rate benchmark that’s 3 points higher than the federal funds rate set by the Federal Reserve Board. When the federal funds rate is 2%, for instance, the prime rate is 5%. Your issuer may express your credit card’s interest rate as “prime plus X,” meaning the prime rate plus a constant based on your creditworthiness.
Your credit card interest rates’ close relationship with the federal funds rate is yet another reason to keep an eye on the financial news. If Fed-watchers expect the federal funds rate to rise in the near term, it may behoove you to accelerate your credit card balance payments.
It bears repeating: Interest isn’t the only cost you may incur with regular credit card use. Most cards carry non-interest fees that kick in under certain circumstances, including:
- Annual fees charged to secure your membership in good standing for the coming 12-month period
- Balance transfer fees and cash advance fees charged when you execute the transaction and fold it into your respective current balances
- Foreign transaction fees charged on purchases made outside the United States and its territories or denominated in foreign currencies
- Late payment fees charged when you miss your payment due date
- Returned payment fees charged if your card payment is rejected due to insufficient funds or a stop payment order
With discipline, you can minimize or these common credit card fees or avoid them altogether without cutting up your cards. Unfortunately, unlike interest charges, which you can eliminate by making timely, in-full payments, some card fees can’t be avoided. The only sure way to evade them is to choose a card with no mandatory fees or swear off credit cards altogether and miss out on potentially valuable perks, benefits, and rewards.
What’s the highest credit card interest rate you’ve ever paid?