How Credit Card Interest Is Calculated

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There are two different ways to use a credit card, as a method of payment or as both payment and finance. When you use a credit card, or a charge card, strictly as a method of payment you pay your bill in full and on time every month, avoiding all interest charges. When you also use your card as a method of finance, you are liable for interest, but it is not that simple.

How Interest Is Calculated

Most credit card issuers use the method called average daily balance. The name is somewhat self explanatory, but here is how it works. Let’s say you get a new card on September 1st. At the end of the month, say September 30th, your statement closes. Each day during that month, the bank’s computers multiply your current balance by the daily periodic rate, which is just your APR divided by 365. The amount of interest accrued each day is then added to your statement at the end of the day. There are two major companies, Bank of America, and Discover, that use daily compounding interest. That means they add your interest from the previous day to the balance the next day. Compounding interest is great for you when you have a savings or investment account, but it is only good for your bank when they use that method to calculate the interest that you owe.

Ok, so you have your statement that get’s mailed to you, in this example, in early October and is due later that month. If there was no previous balance, and you pay this statement in full, all the interest is forgiven. You have then essentially received a free loan by paying the entire balance in full within the “grace period.” Let’s say you charged $1,000 in September, but you chose to only pay $900 by the time your due date came around on October 25th. Your statement will then close again on October 30th and your new balance will include:

  • All the daily interest calculations from day 1, in this case September 1st, until October 30th, so essentially two months worth of interest.
  • The unpaid $100 left over from the September statement.
  • All of the new purchases made since the previous statement closing date on September 30th

Note that the daily balance will decrease by the amount of the payment on the day that the payment is credited to to the account.

How To Stop Paying Interest

To continue with our example, imagine that the credit card holder has decided to pay his or her entire balance in full on the October 30th statement. They issue a check or preferably an electronic payment for the entire balance including all interest charges listed on the statement from October 30th. Imagine this person is very careful to ensure that the entire payment is received by the due date, November 25th. On November 30th, the statement cycle closes again, and this person receives his or her November statement in the mail in early December. This statement will contain the following charges:

  • All new purchases since October 30th.
  • Interest on all purchases since October 30th.

Only by paying off the next statement, the November statement, received in December and due in January, will the interest charges go away. In fact, this person would have been wise to find out what their balance was on the day they were going to make the payment to ensure that the balance is paid in full and that they retain their grace period in the future.

Conclusions

You can see how not making a payment in full on purchases made in September could take until January before no more interest is owed. If you think that is bad, it could be worse. Before the credit card reform law was passed, the CARD Act of 2009, interest was calculated on the basis of double cycle billing. This used the average balance for the previous two cycles, which meant it would take even longer to retire any interest payments. Thankfully, the idea of paying interest on part of a balance that was already paid was determined to be so unfair that it is now illegal.

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