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How Is Credit Card Interest Calculated?

The amount of interest you pay is determined by your APR and the balance on your account; you can stop paying interest entirely by paying your bill in full.

If your credit card has an average percentage rate of 18%, it doesn't mean you'll be paying 18% interest once a year. Your effective interest rate can be higher or lower depending on how you handle your account. It's possible that it'll be 0%. Since interest is measured on a regular basis rather than monthly, and is only paid if you bear debt from month to month, this is the case.

Understanding how credit card companies measure interest will help you figure out how much your debt is really costing you.

How to calculate credit card interest

Credit card interest is calculated in three steps. The video above explains the process in depth, but here's a quick rundown of how it works in general. It's successful. Take a look at your credit card billing statement if you want to follow along. It will provide you with some details.

1. CONVERT ANNUAL RATE TO DAILY RATE

The annual percentage rate, or APR, is shown on your statement as your interest rate.

You'll need to convert the APR to a regular rate since interest is measured daily. Divide by 365 to get the response. Some banks divide by 360; for our purposes, the difference isn't significant because it only affects the result by a hair. The periodic interest rate, also known as the regular periodic rate, is the product.

2. DETERMINE YOUR AVERAGE DAILY BALANCE

The days that are included in the billing cycle will be shown on your statement. The amount of interest you pay is determined by your balance on each of those days.

You begin with your unpaid balance, which is the sum from the previous month that has been carried over. When you make a purchase, your balance increases; when you make a deposit, your balance decreases. Go through the billing cycle, day by day, using the transaction details on your statement, and write down each day's balance.

Add up all of the regular balances and divide by the number of days in the billing cycle until that's completed. The end result is your daily average balance.

3. PUT IT ALL TOGETHER

Finally, calculate your average daily balance by your daily cost, then divide by the number of days in the billing period.

Your actual interest payment can vary slightly from this estimated sum depending on whether your issuer compounds interest daily or monthly. Compounding is the method of applying accumulated interest to an outstanding balance, resulting in interest on interest being paid.

Because of compounding, you can end up paying more in interest than your APR. Assume your average daily balance over the course of the year was $1,000. You'd pay $180 if the bank charged 18 percent interest only once a year at the end of the year. However, since interest compoundes, you'd be on the hook for closer to $195.

How does credit card interest work?

Only if you bear a balance from one month to the next do credit card companies charge interest on transactions. Your interest rate is meaningless if you pay your balance in full every month and you are not paying interest.

Paying in full is obviously the most cost-effective option, but if you always carry a balance, a low-rate credit card will help you save money on interest.

Seeing the equation in motion reveals a simple way to cut your interest costs: Rather than paying once a month, pay twice a month or more regularly. Your average daily balance and, as a result, your interest will be reduced by the extra charge. Let's say you have a $2,000 credit card balance and $1,000 to put against it. Your average daily balance will be about $1,666 if you charged $1,000 on the 20th day of a 30-day billing period. The average daily balance will be $1,500 if you paid $500 on Day 10 and $500 on Day 20. You'd save about ten percent on interest charges.

You can have different APRs for different types of transactions, such as sales, balance transfers, and cash advances, depending on your card.

How do card issuers determine interest rates?

For all consumers, certain credit cards have a single payment APR. Others have a range — for example, 13% to 23% — and the exact rate is determined by your creditworthiness. The lower your rate, the better your credit. The prime rate, which is the interest rate charged by banks to their largest customers, is normally used to set the prices and ranges. When the prime rate rises, credit card interest rates typically rise in lockstep.

The APR is also affected by the type of credit card used. The interest rates on reward credit cards are usually higher.

How can I lower my credit card's interest rate?

Any of the variables that decide your credit card's interest rate are beyond your power. With a higher credit score, you'll have more credit card options. If your credit score has substantially improved, you might be able to negotiate a lower rate with the issuer. However, regardless of the reported APR on your card, there are many ways to lower the effective rate:
If at all possible, pay your bill in full each month to prevent interest.
If you can't pay your bill in full, make a larger payment than the minimum.
Reduce the average daily balance by paying more than once a month.
You're in a great place to manage your curiosity now that you know how it all works.

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