06 Feb 2019   /   0 comments

Knowing Just How Your Credit Card Interest is Calculated.

Caroline Mwandawiro
how credit card interest is calculated

Credit card billings can be confusing, and credit card debt can be just as scary. This is not a situation we want to be put in especially when we do not even understand just how these credit card billings work. This can easily be avoided if, we have a basic knowledge of how to calculate our credit card interest rates.

For instance, if you have an 18% annual percentage rate on your credit card, you do not necessarily get charged that 18% on interest annually. This is because unknown to most people, credit card interests are charged on a daily basis and not an annual basis; but the good news is, you can control how much you accumulate in interest charges on a monthly basis.

This means that you can control what you are being charged on interest rates depending on how your account is being managed. So in fact, you can have an influence over whether your charge on interest rate is high or low. In fact, you can totally reduce it to a whopping 0%. Still a bit confused? Allow me to break it down for you.

 

Calculating your credit card interest

This calculation actually takes a three-step process, and for this, you will want to be sure to have your credit card statement on hand as you will need to refer to it for some information.  Now, this is just a general look at this calculation and how this it works.

 

Make a conversion of your annual rate to daily rate

As I mentioned earlier, your interest is calculated on a daily basis.

Let us go back a little and start with recognizing what your interest rate actually is. For this, please refer to your credit card billing statement; it is put down as Annual Percentage Rate or APR. Now that we have that figured out let us proceed.

To convert your annual rate to daily rate is simple, just divide it by 365. This gives you what is called a daily periodicrate or in some cases, a periodic interest rate. While some banks would divide by 360, for the sake of this illustration, we will stick with 365, do not worry, the difference is only a hair’s breadth.


Find out what your average daily balance is

On your credit card billing statement, you should be able to identify clearly, what days you are billed on. Your balance on those billing days are what determine your interest charge.

To get your average daily balance, you will need to divide up your total daily balance by the number of days in your billing period.

Now, to get your total daily balance is really easy. You will again need to refer to your credit card billing statement for this; let us make use of your carryover balance from the last month.

For every time that your card is billed, your balance goes up and for every time that a payment is made, your balance reduces. Now look through your credit card transactions and for each of your billing days, write down the balance and simply add them all up. That is your total daily balance.


Finally, do the maths

This last step involves first, multiplying your average daily balance by your daily rate and then again, multiplying what you get by your number of billing days. It is simple arithmetic, as easy as ABC.

The actual charge on your interest can be slightly different from this amount you just calculated, and this would hinge on how your credit card company compounds the interest on your card.Whether the interests on your credit card is compounded on a daily or a monthly basis makes a difference.

What is compounding of interests? This is when your accumulated interest is added to your balance that is unpaid; so basically, you are paying an interest on top of your interest.

You may notice that what you are actually payingas interest, is more than your actual annual percentage rateand this is because of this compounding of interests. Let me give you an example. Let us say that your average daily balance for a year comes to an exact figure of $1,000 at an annual interest rate of 18%.

Now should the bank charge your interest once a year, you will be required to pay $180; but because of the compounding on your interests, you may actually have an interest of about $195 to pay. That difference between what you actually pay, and what you are supposed to pay, is in fact as a result of the compound on your interests.

 

How the interests on credit cards work

The trick to it is that credit card companies only charge you interest if your balance is carried over to the next month. So basically, if you are making monthly payments in full, your interest rate does not apply. It is more or less useless since you do not get charged at all.

Now obviously, making your full monthly payments is the logical and most effective way to go about it;but, if you are one to carry over your balance, then, a credit card with low interest can actually help you save up on interests.

The best way to reduce your credit card interest charges when you have a carryover of balance is to split up making your payments over the month rather than paying once. Your average daily balance reduces with each payment you make and as such, so does your interest thereby leaving you with a lower balance and hence, less interest left to pay with each payment you make.

Let me show you a calculation for clarity: for instance, you have a pending balance of $2,000 and what you have at hand to put up for credit card bill payment is actually $1,000. Now if you were to pay all of that $1,000 say on the 20th day out of your 30 billing days, it would bring your average daily balance to say $1,633; but, if you split up that $1,000 in two; first, pay $500 say on the 10th day and then the other $500 on the 20thday, itwould bring your average daily balance down to about $1,467; thereby shrinking up your normal charge on interest by about 10%.

Since different cards usually would have different annual percentage rates for different sorts of transactions, you may come to find out that you have different annual percentage rates for transactions like balance transfer, purchase and cash advance depending on your credit card.


How credit card companies fix their interest rates

Some credit card companies actually would have an interest range usually, depending on the level of your creditworthiness. For example 11% to 25% so basically, the higher your credit worth is, the lower your interest rate actually is. Whereas, some card companies have a fixed purchase annual percentage rate for all their customers.

What is your credit worth? This is simply how suitable you are to receive financial credit based on how reliable you have been in paying back monies you have owed in the past. It is basically determined by your credit score.

Now a credit score is a statistical number that credit facilities use to evaluate how worthy a person is for financial credit based on their credit history. A credit score ranges from about 300 to 850 and, as you can guess, the higher a person’s score is, the more trustworthy the person is considered to be financially so in essence:

  • An excellent credit score is from 750 and above
  • A good credit score is from 700 to 749
  • A fair credit score is from 650 to 699
  • A poor credit score is from 550-649
  • A bad credit score is from 550 and below


The factors that typically affect credits scores are:

  • Your history of payments
  • The total amount of money you have owed
  • The length of your credit history
  • The types of credits you have used
  • Any new credits you may have

These interest rates and interest ranges, usually, are dependent on the company’s prime rate. A credit card company prime rate is the rate of interest charged to the biggest of the bank’s customers. This invariably means that whenever the prime rate increases, the credit card interest rates also follow the same ladder of increase.

Another factor that can determine the annual percentage rate is the type of credit card. For instance, typically, rewards credit cards usually have higher rates of interest than regular credit cards.

 

How to reduce the interest rate on your credit card

Generally, whether you know it or not, you actually are in control of some of the important factors that influence the rate of interest on your credit card. Since higher levels of credit worth improve your options of better credit cards with lower interest rates, you can work on improving your credit score and then try talking to your credit card company as regards to applying for a lower interest rate.

Now improving your credit scores may not be as easy as it sounds, in fact, it would take time. Any sort of quick solution may only end up backfiring. Certain steps have been proven effective in improving one’s credit score based on the factors considered when calculating your credit score. You can simply use these tips to over time, improve your credit score:

  • Setting reminds to make timely payments: Delaying your credit payments is usually one of the major reasons for having low credit scores. You could set up reminders with your bank, or, set a personal reminder to ensure your credit is paid on time.

  • Reducing the amount of existing debt you currently owe: This is not as easy as it seems, but it is probably going to be the most satisfying achievement you will make towards improving your credit score. The first thing to consider is to drastically reduce the use of your credit cards.

    Next, properly look through your account statements, see what you are owing on each account, and create for yourself an active payment plan to cover the debts over a period of time. You may also want to plan to divert more of your available debt payment funds towards the account with the highest interest rate all the while still maintaining a minimum or preferably, if possible, above minimum payment on the other accounts.

  • Try not to open too many credit accounts as this would make you look like a risk especially if you do not have a lengthy credit history.

  • Do not go about opening new credit accounts you do not need in order to have a better credit mix; honestly, it probably would not even matter so much in terms of raising your credit score.

  • Use your credit cards responsibly preferable only in emergency situations.

As I previously stated, improving one’s credit score is not easy, it would require a lot of patience and discipline; but even at that, despite your current credit score, and with little regard to whatever the stated annual percentage rate on your credit card is, you can still effectively chase down the interest rate on your card with these simple steps:

  • Try as much as possible to pay your monthly bill in full. This way, you get to totally avoid the interest charge.
  • If you can’t meet up with the full payments every month, try your possible best to make more than the monthly minimum payments
  • If you are not making the full monthly payments, try to break up your payments to multiple times a month as this would help to reduce your average daily balance.

There it is, credit card interest rates and how they work. All broken down into easy to understand maths, facts, and, a few tips to help you control it. So now you finally understand why your credit card bills look the way they do, and you are better equipped with the knowledge to change that outcome. Take control of your interest charges and save yourself some money on all that compound interest.

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