If you carry a balance on your credit card, you know that you pay interest monthly, but do you know how this interest fee is calculated? Take charge of your finances and get the information that you need to understand where your interest fees come from.
~Finding Your Actual Interest Rate
You probably already know what your APR or annual percentage rate is for your credit card. This is what is commonly called the “interest rate”. If you don’t know your APR, you can find this information on your credit card statement or by calling your credit card company.
Because the APR is an annual rate, you cannot calculate your monthly interest directly from the ARP. Instead, your monthly interest rate is your APR divided by 12. For example, if your APR was 12%, your monthly interest rate would be about 1%. Therefore, if your balance is $1000 at at 12% APR, your interest fee for the month would be 1% of $1000. You can calculate the amount by multiplying 1000 by 0.01. In this case, the answer is $10.
~Your Credit Card Agreement
Before you can calculate your interest payment for the month, you will need to understand the terms of your credit card. You will need to review your credit card agreement information in order to get the details for your card. You can learn more about how to get a copy of your credit card agreement at the Federal Reserve System website. Your credit card company is required to provide this information to you at your request. Your agreement will contain valuable details about how your interest rate is calculated.
~Grace Period
Traditionally, most credit card companies have allowed a grace period of 20-25 days on new charges before interest is charged on those amounts. However, some companies have reduced or eliminated grace periods. In some cases, grace periods will not apply if you carry a balance. In most cases, grace periods will mean that you will not pay any interest on your card if you pay off your balance in full and on time each month.
~Your balance
At first glance, it seems like it would be easy to know what your balance is on your credit card, but it’s more complicated than it might appear to figure out the balance that your interest is being calculated on. There are several different ways that the balance may be determined and you will need to read your credit card agreement to see which one applies to your account.
The interest may be based on either the balance at the start of the billing cycle or the final balance at the end of the cycle. Your balance also might be based on an “adjusted” balance which takes the starting balance and subtracts each payment made during that billing cycle. The total left over is the balance for that month’s interest charges.
A more complicated, but very common, method is to look at the average daily value. In this case, you would add the total balance at the end of each day for the month and then divide by the number of days in the month. Let’s consider a situation where you had a balance of $1000 for days 1-15 and then paid $500 leaving a balance of $500 for days 16-30. To calculate your average daily balance, add 15,000 ($1000 times 15 days) + 7,500 ($500 times 15 days) which equals 22,500. Divide this by 30 days in the month to get your average daily balance ($750).
You can see why the method to calculate your balance matters. If the interest was calculated on the ending payment or according to the adjusted balance in the last example, it would be based on $500 instead of $750, meaning a lower payment.
You may not choose to calculate your interest fee each month on your own, given how complicated it can be, but it’s important to understand how your interest is calculated. In some cases, this may help you to pay less interest overall, but at least it will take away some of the mystery of your next credit card bill!
Sources:
Consumer Credit Card Agreement Search, Federal Reserve System
How Credit Card Finance Charges Are Calculated, Financial Web
Calculating Card Interest, Walletpop.com