How Credit Cards Calculate Interest

If you’re like me and you always pay the amount owing on your credit card by the payment due date, you never have to pay interest, so you may not much care what your interest rate is or how it’s calculated. But if you carry a balance, or if you ever take cash advances, read on.

Interest on a credit card is charged differently depending on the type of transaction on the card. Maybe you made a new purchase. Maybe you’re carrying a balance from last month, which would be a “previous purchase.” Perhaps you took a cash advance. Or maybe in an attempt to get your interest costs down, you did a balance transfer.

New purchases usually don’t attract any interest unless there’s a previous balance on the card or you end up paying after the due date. At that point, the interest clock clicks on back to the date of the purchase. No grace period! If you carry so much as a penny on the balance, then instead of getting a free ride from the date of purchase through to the date owed the following month, the interest clock clicks on the minute you do the transaction.

The interest-free or “grace” period never applies to cash advances. Yup, the minute you pull that money off your card, the clock clicks on and you start paying interest, usually on your entire balance. Ditto balance transfers unless you have a special deal going.

The interest you’ll pay is calculated in one of two ways:

  • using the "average daily balance method" or
  • using the "daily balance method".

While these calculations are different, they often yield the much the same results.  If you don’t much care, skip the next two paragraphs. If you really want to know the difference… well… here ya go:

Credit cards calculate the average daily balance by adding up the balance at the end of each day and then dividing the total by the number of days in the billing period. The answer is then multiplied by the daily interest rate (the annual interest rate divided by 12). They multiply the result by the number of days in the billing period (30 in June, 31 in July).

The daily balance method calculates interest owed at the end of each day. They multiply the daily balance by the daily interest rate, adding up the daily interest charges to obtain the amount of interest charged for the month.

Everybody back?
Credit card companies use one of two methods to decide whether the interest-free period applies to your new purchases:
On some cards, the interest-free period applies to your new purchases if you pay your current month's balance in full by the due date. This can be called “method 1” or “one cycle billing”.

But some credit cards want to penalize you when you carry a balance even for one month. In an interest rate grab, “method 2” or the “two cycle” billing was born.  With this method, the interest-free period applies to your new purchases only if you pay your current month's balance in full, by the due date, and you did not carrying a balance from the previous month.

I find it interesting that in all the chatter about cardholder rights and changes proposed by the Feds to protect consumers, two-cycle billing never saw the light of day.  And where is the protection for people – students in particular – who are offered credit with no visible means of repayment? And don’t get me started on over-limit fees or any of the other rapacious fees credit card companies pull out when they need to compensate for all the bad lending they did.

Credit cards can also charge a different interest rate for things like introductory offers, cash advances or balance transfers. Since those rates are often calculated in a different ways than the rates charged for purchases, you need to be careful when you use your cards.

Often, for example, if you do a balance transfer, you should NOT use that card for any additional purchases. Why? Well, while the balance transfer offer may seem like a gift, the new purchases interest rate can be through the roof. And since all your payments will go to the “balance transfer” pot first, your “new purchases” pot will continue to accumulate at that much higher interest rate.

The recent Fed plans to try to protect consumers from the big bad credit card wolves does address this issue, but nothing has been cast in stone yet. So sometime in the future consumer payments may have to be assigned to the balance with the higher rate, or they may be spread between the two or more pots based on the relative size of the balance, but who knows.

While it may feel like torture to read your credit card agreement, if you don’t you’re walking blind into something that may bite you in the butt down the road. And whenever your credit card company sends out a notification that your terms and conditions have changed, pay attention.

It was a lack of attention that allowed the Method 2 calculation or “two-cycle billing”, which was born in the U.S. where credit card companies regularly stick it to their customers, to take hold in Canada. If more people had had their heads up and rebelled, our lenders would never have kept this option. Now it has a strong foothold, it would take a tsunami of customer cancellations to have it reversed. That’s ground we’ve lost as consumers that we’ll never regain.

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