How Credit Cards Calculate Interest
Posted by Gail | Filed under Credit Wise
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 as a 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 back to the minute you did 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 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 365). 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 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 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.
June 21, 2010 at 7:22 am
I’ve found that I don’t have a grace period on my card. I have to pay off new purchases before the bill is printed (which for me is on the 3rd of the month) or I get zinged with interest. Since I can see the balance online I can do this easily.
regards,
Jason
June 21, 2010 at 7:55 am
I’m with you, Gail. I pay my credit card off in full every month and never pay interest. I prefer to use debit but a credit card comes in handy if I’m traveling or out of the country, especially in Europe. It’s a waste of my money to pay the banks for the use of their card.
June 21, 2010 at 8:35 am
Wow, that is a dizzying amount of calculations!! It makes me very glad that my card doesn’t often see sunlight.
June 21, 2010 at 8:43 am
Beware that annual fees (if applicable) are also subject to interest if you carry a balance. I have a “low-rate” card with a $20 annual fee. Since this card actually has a higher rate of interest than my unsecured line of credit and another credit card I own, I never carry a balance on it at the regular “low rate” amount of 11.99%. However, I have kept the card, as I’m regularly sent balance-transfer offers with very low interest rates (commonly between 1.99% and 3.99%).
A month or so ago, I was sent some 0% balance-transfer cheques for this card. I transferred what I owed on my LOC and my other low-rate credit card to this card (and will transfer them back before the due date is up at the end of Oct). On my last statement, my $20 annual fee was posted. I was frustrated to find out I was being charged interest on it because of the outstanding balance transfers!
June 21, 2010 at 8:46 am
I pay my credit card in full every month, but you really have to be on top of it to do it. My RBC credit card has a 17 day grace period, but by the time the bill arrives in the mail – it is something like 5 days. Totally ridiculous. Good thing I can see my bill online. I found out about about the two month thing a couple of years ago, when I underpaid my bill by $4 and got zinged on some big vacation charges. Learned my lesson, I watch my credit cards like a hawk now.
June 21, 2010 at 8:53 am
I actually believe Gail is slightly incorrect with her terms or math above.
The daily interest rate should be the annual interest rate divided by 365 (number of days in a year). The monthly interest rate would be the annual interest rate divided by 12 (number of months in a year).
Doing her multiplication formula to figure out how much interest you will be charged in a month will yield you an amount of interest a little over 30 times higher than you will actually be charged.
Richard.
June 21, 2010 at 10:08 am
@Jason,
Why don’t you shop around for a new card, my PC Mastercard gives me up to a 6 week grace period if I time major purchases correctly. I plan everything for after the 21st of the month and then I won’t see a charge until the 12th of the month 6 weeks later and free groceries dosen’t hurt either.
Also I find CC offers come through that offer 0% interest sometines for extended periods the last one was from MBNA @ 0% for 18 months so I transfered a small remaining car loan it and will be paid by Christmas. After it’s paid I just don’t use it anymore, this has happened twice, they are few and far between but they are out there. I’m sure the company hates me doing this but if they are going to offer me zero intrest I’ll use it.
June 21, 2010 at 10:23 am
@Goal 0 Debt, your CC company won’t hate you. Even if you don’t pay interest, merchants wherever you’ve used your card do. They pay a fee between $1 and $2 for every cc transaction made at their store. It’s the same with a debit card and that’s why you’ll see signs that say you can only pay with debit if the purchase is more than $5. If it’s less, they make no profit so there’s no point for them.
June 21, 2010 at 10:46 am
That’s true Amelia, the only thing is that I tend to only use the card once for a balance transfer pay it off and don’t use it again. After I have taken advantage of their 0% that’s it for the card. And as I said I only see these offers once in every 20 or so card offers that come through. I did this with a Citi bank MC and once it was paid they never sent me another thing, so I assumed they didn’t like this all the cost rests with them.
June 21, 2010 at 11:03 am
Gail, great summary. I was enlighted to two cycle billing by my card company. It seems I had to pay off the current balance and not have a new balance to get the grace period. Very shady and I can see it didn’t get any attention with the reforms.
I think the balance transfer interest was addressed at least in the US. Also, now on all the bills card companies have to tell you how long it will take to pay off if you pay the minimum and the total amt paid. Boy, when you see that you would pay nearly 4 times for that $100 shopping trip by paying the minimum, you realize how crazy that is.
June 21, 2010 at 11:44 am
i am one of those digging out of debt and i thank you gail for the explanation in plain english of the 2 interest calculation methods & reminding me to read the oh-so-boring-but-necessary terms information on my cards.
i have put the cards away and am doing well paying off existing balances but that little box showing how many months to pay-off if i pay only the minimum scares the you-know-what out of me. thankfully i have always paid more than the minimum but damn! it amazes me what the cc companies can get away with here in the states!
and believe me, i am painfully aware that i made this mess, and it’s up to me to clean it up. so onward i go. the more informed i am, the better i feel about reaching debt-freedom…thanks again gail, for a very timely blog.
and thanks all who respond; your comments & stories help inspire me to keep on working toward my goal.
June 21, 2010 at 11:57 am
When we were paying out our debt I played a little head game with myself which really, really changed the way I looked at interest – ’cause of course I never looked before. In my debt payment budget I had two columns – one was for the payment of goods and the other was for the payment of interest (cost of borrowing). Every month we paid the minimum (plus however much else we could put on it which gradually increased as we got our finances and budget in line) and all the interest charged. The way I looked at it was that by paying the interest every month I was at least not paying interest on the interest. Now I know that the way the cards charge interest on the balance it doesn’t really work this way but it did help me in my mind. By doing this I could see the actual balance of the goods purchased and cash advances decrease steadily and seeing the amount of interest we had to pay every month sure kept us focused. When you see $127 on one card alone in interest you see how foolish you have been and you start to think – wow I could have spent that on something istead of giving it to the bank. Perhaps this is my simple mind at work but it worked for me.
June 21, 2010 at 1:53 pm
If you have a CC though your everyday bank I highly recommend the following to protect your credit rating (I’m not sure if all banks do it, but I know RBC does):
Call the bank and ask to have the minimum payment on your CC paid automatically each month. That way if you happen to forget to make the payment at least the minimum payment will come out. If you make the payment (or a larger one) then nothing will happen.
If you’re one of the people that keeps a zero balance on their CC you can have the entire balance paid off monthly automatically. One less thing to think about.
I have the balance paid off completely monthly, and any time I use online banking I mentally subtract the CC balance from my account balance to figure out how much I actually have (sorry Gail, no jars yet). In the past as a student I missed my payment date twice by 1 day with the money in my account. Marks like that stay on your credit report for 7 years.
June 21, 2010 at 2:45 pm
[...] original post here: How Credit Cards Calculate Interest « gailvazoxlade.com By admin | category: credit interest low rate | tags: auto-loan, card, higher-rate, [...]
June 21, 2010 at 4:04 pm
[...] post: How Credit Cards Calculate Interest « gailvazoxlade.com By admin | category: credit card low | tags: card, credit-card, credit-cards, [...]
June 21, 2010 at 6:34 pm
I accidently paid my credit card 4 days late recently (2 of those days because it was paid on the weekend which doesn’t count as a working day, but does count as a interest day). I put absolutely everything on my credit card and pay in full each month, so my charges are often high.
I realized I paid over $150 in fees & interest thanks to being four days late. I’m not only charged for the days I was late, which I admit I owe, but i’m also charged a fee, and the interest is retro dated to the date of each items purchase, and now everything I buy for the next three months accumulates interest.
I’m sorry. $150 is a ridiculously excessive charge for being four days late. So I called up my credit card told them that, and asked them to suspend my account for three months. If you don’t make any new purchases on it, there’s nothing to charge fees/interest on. They quickly came back and said they would reverse all the fees/interest and and remove any interest I would have been charged “just this once”.
I know it’s not just this once, because they’ve reversed it before when I’ve had other problems. Don’t let them push you around!
June 21, 2010 at 8:24 pm
As a person who is digging out from under C.C. debt, for me it was just get rid of the cards, deal with money or my debit card. it is hard to rent a hotel room without one, but I can live with that. No more eBay, I just am not good with C.C. so do not deserve one.
Watching Gail’s show woke me up and I am a senior citizen, how come I did not know better ? Thank you Gail.
Velda
June 22, 2010 at 12:07 am
This paragraph should read:
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 365). They multiply the result by the number of days in the billing period (30 in June, 31 in July).
June 22, 2010 at 6:24 am
Thanks Richard.
June 22, 2010 at 10:54 am
@ ajg – how are they pushing you around? You were the deliquent party and know the rules and didn’t play by them.
You also specify the $150 in fees/interest as ridiculous but don’t mention the amount outstanding. It might be $35,000 for all we know, in which case to me $150 doesn’t sound bad. And remember, it’s not 4 days interest you’re being charged, it’s the entire period because you didn’t pay on time, which is reasonable. The fact that you’ve managed to get around paying this (again) probably only means that later on they will raise the rates for everyone to compensate at some point.
I really don’t understand people sometimes. You sign an agreement, it specifies when payments are due, and then don’t do it and somehow it’s terrible for the company to hold you accountable. Blech.
June 23, 2010 at 11:51 am
Richard,
Gail is actually correct on her calculation for interest, I worked for a major credit card company for quite some time not to name name but it’s in your wallet. Read the fine print of your credit card statement, the calculation is (daily interest) X (# days in cycle) X (average daily balance). If you took the monthly interest it wouldn’t account for the different # of days in the billing cycle.
Jenn
June 23, 2010 at 12:08 pm
I’m a “no balance” carrier but I’ve made payment mistakes too. When I realize I’m a day or two late – I login online and see the total owing – last statement plus any unbilled charges. I pay everything plus 20 %. I then put the card in the freezer.
I call the cc company and explain my mistake and they usually forgive some or all the interest.
The important thing is to clear the entire balance (including all recent charges that aren’t on the statement) and clear the accumulated interest (which I have to estimate because I haven’t been billed for it yet). This stops further interest from accruing.
Then I don’t use the cc until I get a completely zero statement.
I’ve learned from experience that as soon as I have made a payment mistake I need to mitigate the damage quickly or it gets out of control fast.
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June 9, 2011 at 10:13 am
How Credit Cards Calculate Interest ? gailvazoxlade.com…
[...]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. …. In my debt paym…
June 9, 2011 at 3:41 pm
How Credit Cards Calculate Interest « gailvazoxlade.com…
[...]How Credit Cards Calculate Interest. Posted by Gail | Filed under Credit Wise … [...] original post here: How Credit Cards Calculate Interest « gailvazoxlade.com By …[...]…