Credit card users love the convenience and security that these products offer, but they hate paying interest. When cardholders are unable to pay their entire balance in full, interest will inevitably be accrued. While most credit card users will pay interest on the credit cards at some point, few are aware of exactly how that interest is calculated.
Since the passage of the CARD Act of 2009, non-business credit cards must all calculate interest payments in the same way, called the Average Daily Balance method. To understand how this works, consider this example: A cardholder has a credit card that has a statement period that begins on January 1st, and closes on January 30th. During this time, the cardholder makes the following charges; $100 on the 10th, $200 on the 15th, and $300 on the 20th. At the end of the statement period, the bank will add up each day’s balance. For the first ten days, the cardholder had a balance of $0, followed by a daily balance of $100 for the next five days, $300 for the next five days, and $600 for the last ten days of the statement period. ($100 x 5) + ($300 x 5) + ($600 x 10) = $500 + $1,500 + $6,000 or $8,000.
To determine the average daily balance, the bank will divide the total of each day’s balance by the total number of days in the statement period. $8,000/30 = $266.67. Finally, this amount is multiplied by monthly percentage rate, which is simply the Annual Percentage Rate (APR) divided by 12. If the card has an APR of 18%, the monthly percentage rate will be 1.5%. $266.67 x .015 = $4.00 in interest.
If this cardholder had not previously carried a balance, he or she will receive a statement in early February showing just $600 in charges, as the interest will be waived if the balance is paid in full by the due date. If on the other hand, the cardholder pays some amount less than $600, the cardholder will owe $4.00 in interest, and his or her next statement will reflect the continued accrual of interest during the subsequent statement period, which has already begun by the time last month’s statement was sent. When each payment is received, the cardholder’s average daily balance will fall, but interest keeps accruing on each day’s balance, including every new purchase, until the entire balance is paid in full. Furthermore accrued interest is added to the cardholder’s credit card balance each month, adding to the principal and increasing the interest that will be incurred the following month. This process is known as compounding interest.
By completely understanding how credit card interest is calculated, cardholders will be able to anticipate the costs of carrying a balance, and make the best decisions regarding their credit card use.