How Credit Card Interest Works

By Leni Parrish on September 26, 2012

Credit Card InterestInterest of any kind can be quite complicated. Most financial products – including credit cards – are often advertised with two different rates. We’ll show you how to calculate the interest on your credit card so that you can verify your monthly bills for accuracy, realize how expensive interest on a credit card can be, and get a better understanding of how your credit card works.

Credit card companies advertise an interest rate known as APR, or annual percentage rate. The annual percentage rate is the rate of interest that the credit card company uses to determine your monthly interest charges.

The annual percentage rate might be something like 25%. Here are the steps to follow to calculate your interest on your credit card.

1.Calculate your average daily balance – Your average daily balance is the average balance during the preceding month. If you had a balance of $1500 for half the month and $500 for the other half, your average daily balance would be $1,000.

2.Calculate the daily rate – To calculate the daily interest rate, the annual percentage amount is divided by 360 days. (Notice that the number of days in a finance year is 360, not 365 or 366 in leap years.) If your annual interest rate were 25%, then your daily rate of interest would be something like .0694% per day.

3.Calculate the growth – In a billing cycle of 30 days, a credit card company would calculate the total interest growth over the period with compounding. Using your daily interest rate of .0694% per day, your balances would grow by 2.1%.

4.Multiply interest by the average daily balance – Finally, the compounded rate of interest is multiplied by the average daily balance. In this case, the credit card had a balance of $1,000, so the total amount of interest for the period is $21.

Knowing how to calculate the amount of interest due on your credit cards is a very important skill that transfers to all parts of your personal finances.

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