If you think credit card interest is painful, try figuring out how it’s calculated. Photo: B. Rosen
Paying credit card interest is painful enough. Figuring out how that interest is calculated? That’s almost as bad! The entire process is rife with complexity — and not always set in stone.
Still, if you’re carrying a balance on a credit card, you should know the science behind how much interest you’ll ultimately pay. This post aims to answer the question: “How is credit card interest calculated, anyway?”
How to Calculate Credit Card Interest
When you’re carrying a balance on your credit card, you probably focus most of your attention on your card’s APR, or annual percentage rate. Although that’s a decent way to figure out how much you’ll pay over time, it’s not the best.
Why? Because credit cards don’t add interest to your account annually as the name suggests – they actually charge interest every day.
This daily interest calculation is decided on using your cards DPR, or daily periodic rate. You can figure out your DPR by taking your APR and dividing it by the number of days in the year.
One caveat, though: Some banks divide by 365, while others divide by 360. Confused yet? We thought so.
Here’s an example that shows how it works:
Let’s say your credit card’s APR is 11%. Divide that number by 365, and you’ll discover that your daily periodic rate is 0.03%.
Here’s where things get even trickier. When credit card issuers charge interest using your DPR, they figure how much you owe using your average daily balance. This is because your credit card balance can vary widely throughout the month as you make partial payments or more purchases.
Here’s an example to illustrate how this works:
Let’s say you owe $500 on your credit card at the beginning of the month. Fifteen days after the new billing period begins, you charge another $500 on your card. Your card issuer determines your average daily balance for the month by multiplying each balance by the number of days you carried it, then combining them and dividing by the total number of days in the month:
($500 * 15 days) + ($1,000 * 15 days) = $22,500/30 days = $750
Using the daily periodic rate above, you’ll be charged $6.75 in credit card interest that month:
$750 * 0.0003 * 30 days = $6.75
How Is My APR Decided in the First Place?
No one wants to pay a lot of credit card interest, so it’s always in your best interest to choose a card with a low APR. The good news is, there are a wealth of credit card offers with low APRs, or even promotional 0% APRs, on the market. The bad news is, you may not always be able to qualify for them – at least not yet.
That’s because card issuers use your personal information and credit history to determine what type of interest rate they’ll charge you.
For example, those with good and excellent credit who have scores over 690 will generally qualify for cards with the most attractive rates. Meanwhile, those with a FICO score in the average, poor, or bad range (630 and below) may have trouble qualifying for cards with the best terms. Compare your FICO score to these credit ranges to see how your score stacks up:
- Excellent credit: 720 and up
- Good credit: 690 to 719
- Average credit: 630-689
- Bad credit: 300-629
If your score isn’t where you want it to be, take some steps to improve it over time. Above all else, those steps should include paying all of your bills on time, paying off as much debt as possible, and taking care of any delinquent accounts or inaccuracies on your credit report.
Once you do, credit reporting agencies will take note and adjust your score accordingly.
How to Avoid Paying Credit Card Interest
If you hate the idea of paying credit card interest on your purchases, one tried and true method will save you the heartache every time. Pay your balance on time and in full every month, and you’ll never have to estimate an interest payment again.
That’s right; staying out of debt is the only true way to avoid paying interest on your purchases. Here are a few tips that can help you avoid paying interest altogether:
Set a reminder to pay your bill early: All credit cards offer a 25- to 30-day grace period where you won’t be charged interest on your purchases. Paying your bill in full before your due date can help you avoid paying interest altogether.
Only charge what you can afford to pay off each month: If you’re worried about overspending, only use your card for purchases you have the cash in the bank to pay for. One way to keep track is to carry a notebook in your pocket and write down each purchase you make on credit.
Take advantage of a 0% APR balance transfer offer: If you’re paying too much interest on a balance, you might want to consider transferring your balance to a different card with better terms. Some cards even offer 0% APR on balance transfers for a limited time.
Use your card only in emergencies: If you’re still worried you’ll overspend, it might be wise to save your credit card just for emergencies. For everyday purchases, stick to cash or use a debit card connected to your bank account.
The post How Is Credit Card Interest Calculated? appeared first on The Simple Dollar.
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