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How is Credit Card Interest Calculated

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How is Credit Card Interest Calculated

Credit card companies make money by charging interest on the credit extended to you. If not for credit card interest, there would be no reason for credit card companies to exist. That’s why credit card interest is so important to them, and also, to you, as a credit card user. We discuss how is credit card interest calculated and how you can take advantage of this information. Read on for more!

What is Credit Card Interest?

A credit card interest is quite simply the fee paid by you, as a borrower, against a fraction of the money you owe to the credit card company – called, the outstanding balance. It is by charging an interest that credit card companies make their profits and stay afloat. There is no such thing as an interest-free credit.

What is Credit Card Interest Rate?

A credit card interest rate is the rate charged by the company, according to which the credit card interest is calculated. The same interest rate can be used to calculate the credit card interest in 3 different ways, with varying results. The three methods of calculating the credit card interest are basically three different ways of calculating the credit card balance, to which the same credit card interest rate is applied.

Here are the 3 methods used to calculate the credit card balance:

  • Adjusted Balance Method: An adjusted balance is got by subtracting all credits or payments from the previous balance, in the current billing cycle.
  • Average Daily Balance Method: An average daily balance is got by subtracting the credits or payments from the balance each day. Now all the balances are added up, and the total got this way is divided by the number of days in the billing cycle, to arrive at the Average Daily Balance.
  • Previous Balance Method: It is easy to calculate the Previous Balance. It’s the balance left over from the last billing cycle, without any adjustments being made.

You are advised to opt for credit cards that allow for the credit card interests to be charged on the Adjusted balance, rather than on the Average Daily balance or Previous balance. This way the charges on your card are kept to a minimum. But if the choice is between the Average Daily balance and Previous balance, opt for the former, as it is relatively cheaper. All credit card companies in the United States are required by law to list the method used by them to calculate the credit card interest in the monthly statements sent to you.

Let’s discuss how to calculate the credit card interest based on the Average Daily Balance, to give you a good idea of how the calculations are done.

Say you have a balance of $1,000 carried over from the previous month. You haven’t used the credit card for the first 10 days of the new month, but on the 11th day, you make a purchase worth $200 using the credit card. Now, the balance from days 1 to 10 was $1000, from 11 to 30 is $800. Assuming you have not made any further purchases in the month, here’s how your Average Daily Balance for the month is calculated.

#1. (10 x 1,000) + (20 x 800) = 16,000.

Divide this by the number of days – 30 days.

 #2. 16,000 / 30 = 533.33.

Your Average Daily Balance is hence $533.33.

Now suppose your periodic interest rate – called APR – is 10%. Divide this by 365.

#3. 0.10 / 365 = 0.00027

So the daily interest rate is 0.027%. Now multiply this by the average daily balance and the number of days (30)

#4. 533.33 x 0.00027 x 30 = 4.31

So, you have been charged $4.31 on your credit card usage for the month.

This is how your credit card interest is calculated.