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How Does Credit Card Interest Work?

You may know your credit card will charge interest if you don't pay off the balance each month, but do you know how that credit card interest actually works? Credit card interest is calculated based on an account's average daily balance during the statement period, and is compounded daily. However, interest charges are usually waived when cardholders pay their entire statement balance by the due date. Here's what you need to know about how credit card interest works.

What's the Difference Between the Interest Rate and APR?

Sometimes you see the terms "interest rate" and "APR" thrown around interchangeably, but they're actually separate concepts in some contexts. For mortgages, car loans and other types of installment loans, the APR, or annual percentage rate, includes both interest and other charges such as points and fees. So your interest rate and APR on a mortgage, for instance, will slightly differ.

But when it comes to credit cards and other types of revolving credit accounts, the two terms mean the same thing: Your APR is your interest rate. Any additional credit card charges, such as annual fees and late fees, are not figured in to your APR. To find out more, see "APR vs. Interest Rate: What's the Difference?"

Different Types of APRs on Credit Cards

It would be easier to compare credit card APRs if each card had just a single rate. However, most cards have several different types of interest rates. For example, many cards offer a low introductory rate on new purchases, balance transfers or both that you can take advantage of when you are approved for the card. These are usually 0% APR, which differs from the standard rate that applies once the promotional rate ends.

In some cases there's a standard APR that applies to new purchases and a separate rate that applies to balance transfers. Then there's the APR for cash advances, which is typically higher than the interest on purchases. Thankfully, you can easily view all of these rates in a format that's easy to read. Credit card issuers are required to disclose these rates in a standardized table format called a Schumer box (see example below).

How Is Credit Card Interest Calculated?

It's not quick or easy to calculate your account's interest charges, but if you want to figure out yours, follow these steps:

1. Calculate the Daily APR on Your Credit Card

To do this, divide the APR by 365 (the number of days in the year). So if your APR is 16%, then 0.16 / 365 = 0.00044 is your daily periodic rate.

2. Calculate Your Average Daily Balance

Remember, your interest is assessed on your average daily balance. So you have to figure out what that is. To do so, you'll have to look back at your statement.

Start with the unpaid balance—the amount of money you carried over from the previous month's statement. Next, go through your statement to determine what each day's balance was. Note: Your credit card won't tell you your daily balances for the month; you'll need to do it yourself by adding or subtracting individual charges for each date of the billing cycle as they appear on your statement. Add up each daily balance amount and divide it by the number of days in your credit card's billing period. That's your average daily balance.

3. Multiply Your Daily Periodic Rate by Your Average Daily Balance

Now, multiply the daily periodic rate calculated in step 1 by the average daily balance from step 2.

Let's say your average daily balance came out to $1,200. The calculation would be: 0.00044 x $1,200 = $0.53

4. Multiply by the Number of Days in Your Billing Cycle

Finally, you have to multiply the figure from step 3 by the number of days in your billing cycle.

If your billing cycle was 30 days, then you multiply $0.53 by 30 to equal $15.90. You will be charged approximately $15.90 in interest for this billing cycle.

5. Factor In Daily Compounding

Most credit card issuers will compound an account's interest charges daily. That means it will actually multiply each day's average daily balance by the account's daily periodic rate, and then add that amount to the next day's average daily balance.

To determine this manually would be extremely time-consuming. Thankfully, the effects of daily compounding are relatively minor over the course of a single month, so you'll get a pretty good estimate from the amount you arrive at in step 4. However, the higher the interest rate, the greater the effect daily compounding will have on the final amount you'll be charged in interest in a given month.

How to Avoid Paying Credit Card Interest

Of course, none of these interest rate calculations are relevant if your card issuer waives the interest charges. Nearly all card issuers won't impose interest charges when the entire statement balance is paid in full on or before the due date. The period of time between the statement closing date and the due date is called a grace period.

Technically, interest charges apply during this period, but they are waived if the entire balance is paid in full and on time. By law, credit cards that offer a grace period must give you at least 21 days to avoid interest by paying your balance in full. For more information, see "What Is a Good APR for a Credit Card?"

The Bottom Line

Calculating credit card interest may be of interest to some, but just understanding how it works is probably more important. When you realize the factors that affect your credit card's interest charges, you can begin to make the right decisions to minimize or avoid these charges altogether.

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