How is interest calculated on credit cards?
The answer may vary depending on your credit card issuer, but we can give you a general idea of how it works.
Generally, credit card companies use something called the average daily balance method to calculate interest charges.
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The Basics of Interest Charging
If you have a credit card, you’re probably aware that you’ll be charged interest on your balance if you don’t pay it off in full each month. But how is that interest calculated? Although credit card interest is complicated, this section will break it down for you.
What is APR?
Annual Percentage Rate (APR) is the cost of borrowing money for one year, expressed as a percentage. For example, if you borrow $100 at an APR of 10%, you will owe $110 at the end of the year.
APR includes not only the interest rate, but also any fees charged by the lender. For credit cards, this could include an annual fee, balance transfer fee, or cash advance fee. The APR is important because it lets you know how much it will cost you to borrow money on your credit card over the course of a year.
APR is different from your card’s interest rate, which is the cost of borrowing money for one month. Your card’sinterest rate may be lower than its APR, but that doesn’t mean there’s no cost to borrowing money on your credit card. In fact, most cards charge interest at a daily rate, which means that you accrue interest every day that you carry a balance on your card.
To calculate your daily interest charge, divide your APR by 365 (the number of days in a year). Then multiply that number by your current credit card balance. For example, if your APR is 18% and your current balance is $1,000, your daily interest charge would be $0.49 ((18%/365 days) x $1,000).
Interest is charged on your average daily balance during the billing cycle. To calculate your average daily balance, add up each day’s balances during the billing cycle and divide by the number of days in the billing cycle.
For example, let’s say you had a balance of $1,000 on Monday and Tuesday and a balance of $500 on Wednesday through Friday. Your average daily balance would be: ($1,000 + $1,000 + $500 + $500 +$500)/5 days = $900.
What is daily periodic rate?
The daily periodic rate (DPR) is the rate utilized to figure the interest charged on your credit card account each day. It’s important to understand how your DPR is calculated because it’s the key number used in determining the amount of interest you’ll be charged on outstanding balances.
Most credit card companies calculate interest using what’s called the average daily balance method. Under this method, the credit card company takes the beginning balance for each day of the billing cycle, adds any new charges and subtracts any payments or credits made during that day, and arrives at a daily balance. The credit card company then adds up all the daily balances for the month to arrive at the average daily balance. (Note: Some companies use a different method called adjusted balance, which subtracts payments and credits made during the month before calculating interest.)
Once the credit card company has your average daily balance, it applies the DPR to that number to calculate the interest charge for that billing cycle.
For example, let’s say you have a credit card with a 17% APR and a $100 balance at the beginning of February. During February, you make no additional purchases but do make a $50 payment on February 15. Your average daily balance would be calculated as follows:
Day 1: $100
Day 2: $100
Day 3: $100
Day 4: $100
Day 5: $100
Day 6: $100
Day 7: $100
Day 8: $100 payable days in billing cycle/balance x DPR = finance charge 28/$25 x .0005 = .036 or 3.6%
To calculate your finance charges for this billing cycle, multiply your average daily balance by your DPR. In this case, that would give you a finance charge of 3.6%.
What is average daily balance?
Your credit card’s interest is calculated based on your average daily balance. This is the balance on your card divided by the number of days in the billing cycle. The interest rate your card issuer charges will be applied to this average daily balance.
For example, let’s say you have a credit limit of $1,000 and you spend $500 during the first half of your billing cycle. You don’t make any more purchases or payments and your billing cycle is 30 days long. Your average daily balance would be $500 divided by 30 days, or $16.67.
If your card has a 15% APR, the interest you’d be charged on that $16.67 balance for one month would be 15% of $16.67, or 40 cents.
How Is Interest Calculated on Credit Cards?
Credit card companies make money by charging interest on the money that you borrow from them. The interest rate is the percentage of the outstanding balance that you will be charged each month. The interest is calculated based on the daily balance of your credit card.
APR x average daily balance = daily periodic rate
The amount of interest you pay on your credit card each month is determined by your annual percentage rate (APR) and your average daily balance.
Your APR is the interest rate charged by your credit card issuer, and can be a fixed rate or variable rate. A fixed APR means that the interest rate will remain the same for the life of your account. A variable APR can change over time, and is often based on an index, such as the Prime Rate.
Your average daily balance is calculated by adding your outstanding balance at the end of each day of your billing cycle and dividing that number by the number of days in your billing cycle.
Daily periodic rate x number of days in billing cycle = interest charged
The daily periodic rate (DPR) is the rate used to calculate interest charges on your credit card balance. DPR is a fraction of the APR and is calculated by dividing the APR by 365 (the number of days in a year, including leap years).
Interest charges on credit cards are usually calculated based on your average daily balance. Your average daily balance is your balance at the end of each day during your billing cycle, divided by the number of days in that billing cycle. This method for calculating interest gives you a monthly statement that shows how much interest you would have owed if you didn’t pay any of your balance during that month.