If you carry a balance on your credit card from month to month, you're probably paying interest charges. First things first: It's best to avoid being charged that interest in the first place. Otherwise, understanding how this interest is calculated can help you better manage the costs of using credit.
The interest rate
Credit card interest rates are typically expressed as an annual percentage rate (APR). This is the rate used to calculate how much interest you'll be charged over the course of a year based on your average daily balance. The higher the APR, the more you'll end up paying in interest charges.
Average daily balance
Most credit card issuers use the average daily balance method to determine interest charges. This takes into account your balance for each day of the billing cycle.
For example, let's say you had a $1,000 balance for 15 days, then paid it down to $500 for the remaining 15 days of a 30-day billing cycle. Your average daily balance would be $750 (($1,000 x 15 days) + ($500 x 15 days) / 30 days).
Calculating interest
To calculate your actual interest charged, the credit card company uses this formula:
Interest Charged = (Annual Percentage Rate / 12) x Average Daily Balance
So if your APR is 18% and your average daily balance is $750, the math would be:
(0.18 / 12) x $750 = $11.25 in interest for that billing cycle
Compounding interest
One costly factor is that unpaid interest from previous cycles gets added to your balance, meaning you end up paying interest on interest over time. What is magic for your savings is devastating for your debt. This snowball effect is why it's best to pay off credit card balances quickly.
The grace period
Luckily, you can minimize interest fees by understanding your card's grace period. If you pay your statement balance in full every month during the grace period, you won't be charged any interest on new purchases for that billing cycle. The interest calculation only applies when you carry a balance past the due date.
By understanding the methods used, you can see how reducing your average daily balance and taking advantage of interest-free grace periods can minimize the amount of interest paid on your credit card balances.