How is Credit Card Interest Calculated?
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How is credit card interest calculated?
Credit card interest is generally calculated by the daily periodic rate times the number of days in the billing period.
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Introductory Paragraph
Credit card interest is the fee charged by credit card companies for the use of their funds. This fee is calculated as a percentage of the outstanding balance on the card. The credit card company will typically charge interest on a daily basis, and will post the charges to your account at the end of each billing cycle.
There are two main methods used to calculate credit card interest: average daily balance and adjusted balance. With the average daily balance method, interest is charged on the average of all balances owed during the billing cycle. With the adjusted balance method, interest is only charged on balances that remain after payments are made.
Both methods can result in different amounts of interest being charged, so it’s important to understand how your credit card company calculates interest before you make a decision about which method to use.
Types of Interest
There are two types of interest that can be applied to your credit card: simple and compound. Simple interest is charged as a percentage of your daily balance and is not compounded. Compound interest is charged as a percentage of your daily balance and is compounded daily.
Simple Interest
Simple interest is a quick and easy way to calculate the interest charge on a credit card balance. It’s not the method used by banks, but it’s a good way to get a ballpark idea of the interest you’ll be paying.
To calculate simple interest, multiply the daily interest rate by the number of days in the billing cycle, and then multiply that result by the balance. (The daily interest rate is the annual interest rate divided by 365.)
Here’s an example: Suppose you have a $1,000 balance on a card with a 15% annual rate and a 30-day billing cycle. The daily rate would be 0.04109% (15% divided by 365). To calculate the interest charge for the month, multiply $1,000 by 0.04109% and 30 to get $12.33.
Simple interest is easy to calculate, but it’s not the way credit card companies figure your finance charges. Most use what’s called average daily balance method, which gives you a higher interest bill than simple interest because it includes new purchases made during the billing cycle.
Compound Interest
Compound interest is interest that is calculated not only on the initial principal, but also on the accumulated interest of previous periods. In other words, compound interest is earned on top of interest.
Compound interest is calculated by multiplying the initial principal by one plus the annual interest rate to the power of the number of compound periods minus one. The total initial amount of the loan is then subtracted from this result to obtain the compound interest.
How is Credit Card Interest Calculated?
Credit card companies make money by charging interest on the money that you borrow from them. They will also charge you fees for things like late payments or going over your credit limit. How is credit card interest calculated? Read on to find out.
Average Daily Balance Method
The average daily balance method is the most common way credit card companies calculate finance charges. To get your average daily balance, the card issuer takes the beginning balance of your account each day, adds any new charges and subtracts any payments or credits, and then divides that by the number of days in the billing cycle. This gives you a daily average balance, which the issuer then multiplies by the monthly periodic rate—expressed as a decimal—to get your finance charge.
Here’s an example: Let’s say that you have a credit card with a $1,000 credit limit and a 18% annual percentage rate (APR). Your monthly periodic rate would be 1.5% (0.18 divided by 12 months). If you had a balance of $500 at the beginning of the month and spent $50 during the month, your average daily balance would be $525 (($500 + $50) divided by 30 days in the month). Your finance charge for the month would be $7.88 ((1.5% x $525) divided 16 days)).
Two-Cycle Average Daily Balance Method
Credit card companies use several different methods to calculate the interest charged on cardholders’ unpaid balances, with the most common being the average daily balance method and the two-cycle average daily balance method.
The average daily balance method calculates interest by taking the average of your balance during the billing cycle and multiplying that figure by the daily periodic rate and the number of days in the billing cycle.
The two-cycle average daily balance method is similar to the average daily balance method, except that it uses a two-cycle billing period. This means that if you carry a balance from one month to the next, your credit card company will calculate your interest using the average of your balances for both months.
Minimum Interest Charge
Credit card companies assess interest on your outstanding balance every day. To calculate the amount of interest you pay each month, your credit card issuer starts with your average daily balance for the month. This is usually your beginning balance each day, plus any new charges and minus any payments or credits that post during the month, divided by the number of days in the month. Then, the issuer multiplies this figure by your daily periodic rate—which is listed in your credit card agreement—to arrive at a monthly finance charge.
Most credit card issuers also impose a minimum interest charge if you owe any interest for the month. For example, if your monthly finance charge is $1.50 and your minimum interest charge is $0.50, you’ll pay $2 in interest for that month.
Conclusion
In conclusion, credit card interest is calculated by taking the daily periodic rate and multiplying it by the average daily balance. The average daily balance is calculated by taking the sum of all daily balances over the course of a billing cycle and dividing it by the number of days in that billing cycle. The daily periodic rate is calculated by dividing the APR by 365.
