Yahoo Finance How Does Credit Card Interest Work?
It might seem hard to figure out exactly how much in interest you'll have to pay on your credit card bill every month, but the calculations aren't as difficult as you might think. Here is how to calculate your interest.
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If you have outstanding credit card debt, it's essential to know how credit card interest works. Those who pay off their balances every month rarely have to deal with credit card interest, because most cards offer grace periods that result in no finance charges if you pay your bill in full.
Yet for the millions of cardholders who carry a balance at least some of the time, finance charges are inevitable. It might seem hard to figure out exactly how much in interest you'll have to pay on your credit card bill every month, but the calculations aren't as difficult as you might think. As you'll see in greater detail below, if you know the interest rate you have to pay, the outstanding balance on your credit card, and the specific terms that your card company sets forth in your customer agreement regarding finance charges, then you can come up with a good estimate of your credit card interest. Here are the steps to follow.
1. Figure out the interest rate you'll be charged
Every credit card has an interest rate, known as an annual percentage rate or APR, that applies to outstanding balances. The higher the rate, the more credit card interest you'll generally have to pay. With some cards, a single APR applies to all of your transactions using your card. Other cards have different APRs depending on how you incur the debt. For instance, a card could three different rates depending on how much you use your card for store purchases, cash advances, or balance transfers respectively. Moreover, if you fail to make a payment on time, then many card companies have what's known as a penalty rate that's higher than the normal APR. That higher penalty rate can even get applied retroactively if you're 60 days or more late on making a card payment.
There are few limits on APRs. Those with good credit can often find 0% introductory rate offers that essentially make credit-card spending interest-free for an initial period of time. At the other end of the scale, APRs of 20% or more aren't uncommon.
Once you know the APR, you'll typically need to translate that into a daily interest rate. To do so, most cards simply divide by 365. So if your card charges an APR of 18.25%, then that works out to a daily percentage rate of interest of 18.25% divided by 365, or 0.05% per day.
2. Figure out your daily outstanding credit card balance
The other part of calculating your credit card interest is to determine how much you had in outstanding debt each day. For example, if you had no outstanding balance on the first day of your monthly credit card billing cycle on June 1 and then made a single $1,000 charge on June 16, then you'll have 15 days' worth of $0 daily balances, and 15 days' worth of $1,000 balances.
Different card companies use slightly different methods to calculate credit card interest. Some companies will calculate interest on a daily basis and then add up the daily amounts to come up with the total finance charge on your bill. Others will average your daily outstanding balances over the course of the month, and then apply a finance charge that's based on the total number of days in the billing cycle. Either method should come up with roughly the same result. For instance, in the example above, say an APR of 18.25% applied. Using the daily interest method, each day with a $1,000 balance would incur $0.50 in interest, and so the total over the 15 days would be $7.50. Similarly, if you take the average balance during the period of $500 and then apply the 18.25% APR to the entire 30-day period, you'll get $500 multiplied by 1.5%, or $7.50.
3. Apply any special terms that your card company requires
Along with general terms similar to the ones described above that govern most credit card interest, card companies typically have certain additional terms in their card agreements that apply to finance charges and can result in changes to the results calculated using the two previous steps. The most common is a minimum finance charge. Typically, if you would have to pay a finance charge but it would be less than a certain amount, then minimums will kick in. Minimum finance charges tend to be relatively small -- $0.50 or $1 are fairly common -- but they still have the impact of potentially raising your effective interest rate on your credit card debt.
How you can pay less in credit card interest
There are several different ways to pay less in credit card interest. The most effective is to take advantage of grace periods whenever possible. That way, you won't have to pay any finance charges at all, and you'll also avoid the potential debt spiral that those who carry balances on a month-to-month basis often suffer.
Another method is to work to reduce your APR. In some cases, those with high APRs can work with their card companies to reduce the rates they have to pay. It's best to talk to your card company after you've demonstrated a history of handling your credit card debt responsibly. If your own card company won't negotiate with you, then going to a competitor to seek a better rate is also a good method. In some cases, doing balance transfers to a new card can not only reduce your general APR but also let you take advantage of the extremely low introductory balance transfer rates that some card companies offer.
Finally, doing whatever you can to make your outstanding credit card balance as low as possible is a good move. Making minimum payments ensures that you'll take the longest possible time getting your debt paid down, and you'll also pay the maximum amount of interest along the way. Even if you can't pay off your balance in full, adding extra amounts beyond the minimum due to your monthly payments can dramatically shorten how long you're in debt, and you'll also reduce your total interest charges substantially.
If you carry a balance over time, credit card interest is a costly tradeoff for the convenience and rewards that many credit cards offer. Once you go through the process of calculating what your credit card interest will be, it's easy to see just how expensive finance charges are -- especially if you don't qualify for low-rate cards. For most people, getting your credit card debt paid down as quickly as possible while also working with your card company to minimize APRs is the best strategy to stop letting your hard-earned money go toward credit card interest.
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