All too often, people get credit cards without having a complete understanding of everything that’s involved. They may be unfamiliar with some of the terminology used or how the interest is calculated, so they don’t really know how much it’s going to cost the in the long run.
Before applying for your next credit card, make sure you know all that there is to know. Sure, the rewards associated with it may be attractive, but after you have figured out what the costs are going to be, they may not seem worth it anymore.
In a perfect world, everyone would pay off the total balance on their credit card every month in order to avoid having to pay interest charges. But in reality, we all know that it doesn’t always work out that way. So, we carry a balance with the knowledge that we will have to pay the interest on it. On your credit card statement, the rate you are paying appears to let you know what the cost of carrying a balance is. But do you really know how much your balance can cost you? Let’s have a look at how to calculate your credit card interest.
What Exactly Does “Annual Percentage Rate (APR)” Mean?
The annual percentage rate that your credit card balance carries is clearly printed on your statement. The only thing is, you’re not charged interest on your balance once a year. Instead, interest is charged on a daily basis. So, the APR is the interest rate that is charged daily expressed in an annual figure.
To figure out what your daily rate is, divide your APR by 365. (Note: some banks use 360 days instead of 365.) So, let’s say you have an APR of 15%. Your daily rate would work out to 0.041% (15% ÷ 365 days = 0.041%)
What’s Your Average Daily Balance?
You are charged interest on your unpaid credit card balance; that’s the amount carried over from the previous month. But banks don’t charge you your daily interest rate on the exact amount of that day’s balance. It is instead applied against the average daily balance for that entire month. So, the earlier you pay down your balance in the month, the less interest you’ll have to pay.
Here’s how to calculate your average daily balance. Let’s say that at the beginning of the month; your balance is $5000. You make a payment on the 13th day of the month for $1500 and a second payment on the 28th day of the month for $1000. That means that for the first 12 days, you carried a balance of $5000; for the following 15 days, your balance was $3500; and for the last three days, your balance was down to $2500. That means your daily average balance was $4000.
(12 days X $5000 + 15 days X $3500 + 3 days X $2500) ÷ 30 days = $4000
So, even though your balance was down to $2500 by the end of the month, you’re paying interest on $4000 for the entire month.
Coming Up With Your Monthly Cost Interest
Now that you have your daily interest rate and your average daily balance, you can figure out how much you’ll be charged in interest for that month. Using our example, here’s how to do it:
Multiply your average daily balance by your daily interest rate and then multiply that by the number of days in the month.
$4000 X 0.041% X 30 days = $49.20
What’s the Moral Of this Story?
It’s easy to see how paying down your credit card balance as early as possible can save you money. For example, had we paid down the total amount paid for the month on the first day of that month, the monthly cost of interest would have dropped to $30.75. Even if we had made a payment in that amount on the day our first payment was made (day 13), there would have been a savings of $6.15 in interest costs for the month.
Now that you understand how to calculate your credit card interest, you can see that the APR is actually a bit misleading. Since interest is accrued over the year, meaning that it is added to your balance every month, the total cost of starting out with a balance of $1000 and carrying it for an entire year isn’t $150 or 15% of $1000. It really works out just over $160, or 16%. Keep this information in mind the next time you apply for a card, and you just may save yourself some money.