How does credit card interest work? It’s actually pretty simple once you understand the basics. We’ll explain how credit card interest is calculated and how you can avoid paying interest on your credit card balance.
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What is credit card interest?
In order to use a credit card, you must first understand how credit card interest works. Simply put, credit card interest is the fee that you are charged for borrowing money from the credit card issuer. This fee is expressed as an annual percentage rate (APR). For example, if your APR is 18%, you will be charged 18% per year on any outstanding balances on your credit card.
Most credit card issuers calculate interest on a daily basis. This means that if you have a balance of $1,000 on your credit card and an APR of 18%, you will be charged $1.50 in interest every day. Over the course of a year, this would add up to $546 in interest charges.
To avoid paying interest on your credit card balance, you should try to pay off your balance in full each month. Many credit cards offer grace periods of 21 days or more, which means that as long as you pay off your balance before the due date, you will not be charged any interest.
If you cannot pay off your balance in full, you should at least try to pay more than the minimum payment each month. The minimum payment is usually calculated as a percentage of your outstanding balance, so if your outstanding balance is $1,000 and your minimum payment is 3%, you will need to pay at least $30 each month.
How is credit card interest calculated?
Credit card companies charge interest on unpaid balances. The amount of interest you’re charged depends on your APR, or annual percentage rate. This is the rate you’re charged for borrowing money, and it’s typically expressed as a yearly rate. Your credit card issuer can change your APR, but they must give you advance notice.
Average daily balance method
With the average daily balance method, your credit card company calculates your interest charges by taking the average of your balance during the billing cycle. To get the average, your credit card company adds each day’s balance during the billing cycle and divides that figure by the number of days in the billing cycle. This method is also called the daily balance method.
Here’s how it works: let’s say you have a credit card with a $1,000 credit limit and a 20% annual percentage rate (APR). During the first half of your billing cycle, you spend $500. During the second half, you pay off that $500 plus an additional $100 so you have a zero balance at the end of the billing cycle. Using the average daily balance method, your credit card company would take the following steps to calculate your interest charges.
First, they would calculate your average daily balance:
$500 (balance at beginning of billing cycle) + $0 (balance at end of billing cycle) = $250
$250 ÷ 2 (number of days in billing cycle) = $125
Next, they would multiply your average daily balance by your APR:
$125 x 20% = $25
As you can see, even though you had a zero balance at the end of your billing cycle and paid off all of your purchases, you would still be charged interest because of the way this method calculates your average daily balance.
Two-cycle average daily balance method
With the two-cycle average daily balance method, your interest is calculated based on the average of your balance during the billing cycles in the current and previous months. The calculation is done by adding together the beginning balances of each day in the current billing cycle, and then adding together the ending balances of each day in the previous billing cycle. This total is then divided by the number of days in both billing cycles combined. This gives you your two-cycle average daily balance.
How can you avoid paying credit card interest?
You can avoid paying credit card interest by making sure that you don’t carry a balance on your card from month to month. Any balance that you carry over will accrue interest at the rate stated in your credit card agreement.
Paying your balance in full every month is the best way to avoid interest charges. If you can’t pay your balance in full, try to pay as much as possible so that you don’t have a large balance carrying over to the next month. Another option is to transfer your balance to a 0% APR credit card so that you can take some time to pay off your debt without accruing any interest.
Whatever you do, just be sure to avoid making late payments, as this will trigger a late fee as well as potential increases to your APR. If you need help getting out of debt, there are plenty of resources available to help you get back on track.
What are the consequences of paying credit card interest?
Paying credit card interest can have a number of negative consequences. For one, it can make it more difficult to pay off your balance in full each month, which can then lead to even more interest charges. Additionally, paying interest on your credit cards can also make it more difficult to qualify for new credit cards or loans in the future. Finally, carrying a balance from month to month can also damage your credit score, which can lead to even higher interest rates in the future.