If you have a credit card, you may know that interest is added to your balance until you pay it off. However, you may not understand what each of the terms surrounding interest rates mean. You’ll hear words like annual percentage rate or APR, daily interest rate and average daily balance.
It can be quite confusing as to what each means and how much interest you are actually paying on your account. Here is a look at some of those terms and an explanation of how interest is calculated and added to your credit card balance.
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What is the Annual Percentage Rate?
When comparing credit cards, you’ll notice that one of the most common terms used is annual percentage rate or APR. One credit card may have an APR of 15% while another one may say it has an APR of 24%. This term can be quite confusing because interest is added to your balance each month rather than once a year.
The APR is the total periodic rate multiplied by the number of times the interest is compounded in a year, and it includes interest and any fees charged to the account. It’s governed by the Truth in Lending Act, which ensures information is disclosed to the borrower to prevent deceptive practices by the lender.
For credit cards, the interest rate is calculated on a daily basis. So, you can discover your daily rate based on the APR advertised with your credit card. You just have to divide the APR by 365, the number of days in one year.
If your card has an APR of 15%, the rate is 0.041% per day. If the rate is 24%, the daily rate becomes 0.088%. This may seem like such a small amount until you realize that it adds up over time as long as you carry a balance on your credit card.
What is Your Average Daily Balance?
The interest charged to your account is calculated based on the amount you owe. What this means is that the credit card company figures the average balance you carried for the entire month. If you made a payment on your balance, it is figured in so that you are not charged interest on the entire balance over the month.
To figure your average daily balance, you must know your exact balance for each day. Say you have a balance of $2,000 and you make a payment where $500 goes to the balance in the middle of the month (day 15). Your average daily balance is calculated as follows: [(15 x $2,000) + (15 x $1500)]/30 = $1750.
This shows that the more you pay off your balance and the sooner you make the payment, the more you save in interest charges. A person who makes their payment early in the month will be charged less than someone who waits until the last day. Now, it’s important to understand that the term month may not be the same as a calendar month.
For a credit card, the month begins whenever the statement cycle ends. If your statement cuts on the 15th, the daily balance begins calculating on the 16th. It doesn’t really matter when the cycle begins because it is still calculated on a daily basis and added on a monthly basis to your balance, but it can help you understand how your interest is calculated and when.
Put the Numbers Together
To know how much interest you are charged in a month, you would multiply the answer you got for your average daily balance by the daily interest rate. Then, take that answer and multiply it by the number of days for that month.
If you have an average balance of $700 with a daily interest rate of 0.088% from the 24% APR, you would pay $18.48 for the month. That doesn’t sound like a lot, but in a year you would be paying $221.76 per year in interest. Instead of spending $700 on those items charged to that card, they’ve actually cost you $921.76.
Credit card companies don’t charge simple interest. Instead, they compound it so that you are paying interest on interest. Each month that you have a balance, the interest from it is added to the balance. The next month you are paying interest on the entire balance, which includes last month’s interest.
So, in the example above, you would pay interest on $718.48 if you made no payments. Your interest for that month would be $18.96. Not much more, but an increase from the previous month.
Looking at the information above, you can see how carrying a credit card balance can be a detriment to your overall budget. If you don’t pay more than the minimum required, you won’t pay off your balance very quickly, which means the interest continues to add up.
This puts money in the pocket of the credit card companies instead of your own. If you can even pay $20 or $50 extra each month, you’ll reduce the amount of interest you pay. This means more of your monthly payment will go towards the outstanding balance.
How Interest Rates are Determined
When comparing credit cards, you’ll notice some carry a higher rate than others. So how exactly do credit card companies determine what interest rate to charge? Several factors impact the rate, including your credit history.
The interest rate is the amount of risk the credit card company carries by extending credit to you. Someone with a good to excellent credit score can often obtain a credit card with a lower interest rate than someone with poor credit.
Rewards cards also come with a higher APR to compensate for the benefits they provide. Of course, you may be able to find an exception to the rule if you do enough research. To qualify for a credit card with a lower interest rate, maintain a good credit score. If yours needs work, focus on improving your credit and in a year or two, you’ll get offers for credit cards with better rates.
While you don’t need to know details of how interest is calculated to pay your credit card bills, it does help to give you an understanding of what you’re paying each month. Once you realize how interest rates work and all of the terms associated with them, you’ll be more aware of the true cost of the purchases you make.
You’ll also better understand exactly what you’re paying when you make your payments each month. Simply knowing about interest and seeing the figures can help you manage your budget better and be more dedicated to paying off a balance as quickly as possible.
The next time you get your credit card statement, calculate the interest on your own and estimate what you will pay the following month to see how it impacts your situation. This process can help you make important decisions about your finances.