Interest rates are high and rising, yet how credit card companies calculate interest leaves even more money in their pockets. When we think of interest, we generally think in terms of simple interest. You have $1,000 as a balance at 15%, meaning you pay $150 dollars a year in interest payments. Unfortunately, this is not how credit card interest is calculated.
There are three key terms that come into effect when calculating credit card interest payments. These include the APR or Annual Percentage rate, the daily or periodic interest rate, and the average daily balance.
Annual Percentage Rate (APR)
The APR is the listed rate on your statement, and the rate disclosed in the fine print. This is typically a margin against prime, and will increase as a direct relation to any increases in the Prime rate. Credit card marginal rates can be as high as 15 percentage points or more, above the prime rate. The large margin creates an average credit card interest rate of 15% and an average of 21% for those with fair credit.
Periodic Rate or Daily Interest Rate
In simple terms the stated interest rate is divided by the number of days in the year to create a daily rate. Some companies use 360 days instead of 365. This rate is charged to the balance on the account resulting in daily compounding of interest, making the effective rate significantly higher than the listed APR.
For example, a credit card with a 15% interest rate using 365 days will have a daily rate of 0.041%. Interest is charged to the account based on the average daily balance and then posts to the account monthly. When balances are carried from month to month, you end up paying interest on interest, due to this compounding effect.
Starting with a zero balance you are granted a 21-day minimum grace period, by law. After the due date of the card passes, if the balance is not paid in full, interest can be backdated to the date of purchase, and the grace period is forfeited. Balance transfers and cash advances do not offer a grace period and often come with a higher interest rate.
Average Daily Balance
Balances are averaged over the month to account for new charges and payments that have been made. For example, if you begin the month with $1,000 and then make a payment 15 days in for $100 you will have $1000 balance for 15 days and a $900 balance for the other 15 days. The result is that the sooner a payment is posted to the account; the less interest is paid.
APR divided by 360 or 365 = Periodic Rate
Periodic Rate X Average Daily Balance X number of days in billing cycle = Monthly interest payment
Credit cards offer variable rates of interest that fluctuate as the Federal Reserve adjusts rates. Over time this will lead to even higher interest rate costs. Taking the previous example of $1,000 balance at 15%; instead of paying $150 in interest, due to daily compounding the annual costs will be $161.80. When larger balances or larger rates are involved, the numbers grow exponentially.
Credit card companies base rates on your credit, presence of rewards programs, and other card benefits. Understanding how rates are calculated on your account can motivate you to reduce debt faster, while understanding the total cost of borrowing, when you choose to carry a balance.