Nobody wants to pay interest on credit card purchases, but you’ll have to if you carry a balance. Understanding how your credit card’s interest is calculated can help you understand what steps you can take to minimize the interest you have to pay. However, you might be surprised at how difficult it can be for you to manually figure out your credit card’s interest charges if you want to double-check your card issuer’s work.
Understanding APR
All credit cards have interest rates that are shown as an APR, which stands for annual percentage rate. You can think of an APR as a standard unit of measurement of interest charges over time. And just like how miles per hour is used to measure speed over shorter distances than a mile, APR is used to determine interest charges over any period of time, not just a year.
[Read: Best Low-Interest Credit Cards of 2017.]
Nearly all credit cards use a variable APR. This means that your interest will vary based on the prime rate, which rises and falls based on monetary policy set by the Federal Reserve. For example, if your credit card has a variable rate of 14.99 percent and the prime rate is 4.25 percent, then your actual rate is 10.74 percent, plus the prime rate.
Thankfully, the prime rate doesn’t change often. Anisha Sekar, personal finance writer and former product manager of credit and debit products at NerdWallet, says, “The prime rate hasn’t moved much — after falling to 3.25 percent in 2008 and holding steady until 2015, it’s held at 4.25 percent in the past few months and isn’t likely to rise in the near future. A change in the prime rate won’t have nearly the same impact as other rate hike triggers, like a missed or late payment.”
How to Estimate Your Monthly Interest Charges
If you want to calculate your credit card’s interest, you have to convert your APR to a daily percentage rate, or DPR, and apply it to each day’s balance. However, calculating your balance and interest charges for each day is a task better suited to a computer than a person with a calculator. To more easily estimate your approximate interest charges for a single month, you can first divide your APR by 12 to learn your monthly percentage rate. You can then multiply your monthly percentage rate by your average daily balance to estimate your interest charges.
For example, if your account has a 25 percent APR, then your monthly percentage rate will be 25 percent/12, or 2.08 percent. If your average daily balance is $1,000, then you will incur approximately $20.80 in interest over a single month.
This estimate will not take into account the daily compounding effects of adding the previous day’s interest to your balance each day. However, the daily compounding will only add a small amount to the monthly interest charges, unless you have a particularly high interest rate or balance.
[Read: The Best Rewards Credit Cards of 2017.]
Finally, you have to estimate your average daily balance, which can be difficult if you are continuously adding new charges or subtracting additional payments throughout the month. Nevertheless, this method can be useful for estimating how much interest will accrue each month on a balance that is fixed or stays within an approximate range.
Reducing Your Interest Charges
Because credit card interest is calculated on your daily balance, you can reduce your interest charges by continuously trying to lower your balance each day. Sekar explains, “Daily interest charges are counterintuitive, since we’re used to seeing our credit card balances on monthly statements. But once you’re past the grace period, every day counts in minimizing your interest payments.”
For example, you can make payments to your account as soon as possible, rather than waiting until your payment due date. You can avoid increasing your account’s daily balance by postponing purchases as long as possible, especially larger ones.
Avoiding Interest Altogether
With most credit cards, there is a grace period, which allows you to pay no interest when you pay off your balance in full and on time. Technically, interest continues to accrue on your balance every day, but the card issuer waives those charges when you pay off your balance within the card’s grace period.
The grace period is the time between your statement closing date (when your statement is compiled) and your payment due date. If your card has a grace period, then it’s required to last at least 21 days, but many credit cards have a grace period of 25 days. If your account has a grace period and you pay your balance in full before the due date, you will completely avoid interest charges. There are some cards marketed to applicants with bad credit that don’t have a grace period at all, so new purchases begin accruing interest right away.
[Read: The Best Credit Cards for Bad Credit of 2017.]
If your credit card has a grace period, you must have a zero balance at the start of each month to use the grace period during the following month. If you carry a balance from one month into the next, you won’t be able to avoid interest charges by paying this month’s statement balance in full. However, paying your next statement balance off will allow you to avoid interest charges the next month.
Another way to avoid interest charges is to open an account with a zero percent APR introductory offer on new purchases, balance transfers or both. These offers will allow you to avoid interest charges on your balance for a limited time, typically between six and 21 months. Interest only begins to accrue on your remaining balance after the introductory period expires.
Many store charge cards offer deferred financing options that calculate interest differently than those with zero percent introductory APRs. With deferred financing, interest accrues on your average daily balance, but it’s waived when it’s paid in full before the promotional financing period ends.
But, Sean Bryant, founder and editor of personal finance website One Smart Dollar, warns, “Credit cards that offer deferred interest also come with drawbacks. If the balance isn’t paid in full by the end of the promotional period, any interest that accrued will be charged. One late payment can trigger deferred interest.”
Bottom Line
It’s not easy to manually calculate your credit card’s interest charges, but it’s important to know how this process works so you can avoid the negative effects of compound interest.
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How Credit Card Interest Is Calculated originally appeared on usnews.com
