If you’re like most credit card owners, you get your bill each month and stare a little mystified at your interest charges. What does it mean if you have a 19.99% interest rate? How do they calculate how much interest you owe? Is it calculated daily, monthly, annually? What about cash advances and balance transfers? If you keep to your minimum monthly payment is it really going to take you “12 years and 4 months” to pay your balance in full?! Read along to gain some clarity and a few coping skills.

When do you pay interest?

Most consumers are aware that if you pay off your credit card balance before the payment due date, you WON’T have to pay any interest. (This interest-free zone is known as the grace period.) This is especially reassuring for those who have credit cards with high interest rates (some as high as 24.99% or higher!) Paying your bill before the due date means interest-free debt PLUS any points or rewards you earned that month. But what if you don’t pay off your balance and instead carry it over into the next month? We’ve all learned (sometimes painfully) that this is when interest steps in to play. Interest will accumulate on:

  • the balance of purchases which have been carried over
  • cash advances (withdrawing cash from your credit card limit)
  • balance transfers (transferring the balance owning on one credit card to another)

Annual Percentage Rate

Along with information on your available balance, credit limit, minimum payment, and payment due date, you’ll also notice the annual interest rate on your credit card statement. This is generally referred to as the Annual Percentage Rate (APR) and refers to the amount of interest you will pay the credit card company on balances carried over. (Cash advances and balance transfers operate under different interest rates, but more on that later.) Don’t let the word “annual” give you the impression that you will be charged interest only once a year. Take your APR, divide it by 365, and you’ll see how much interest you’ll be charged each day. (Ex. 19.99% ÷ 365 = 0.05476712% interest charged per day.)

What would this look like if you made INTEREST ONLY PAYMENTS? Have a look.

Lets say you made a $500 purchase on March 1st on a credit card with an interest rate of 19.99%. If you ONLY paid off the interest each month and none of the principle, over the course of 12 months you would pay $99.95 in interest (500 × 0.1999 = 99.95) OR $8.33 per month (99.95 ÷ 12). If you thought you’d be paying 19.99% ($99.95) every month, you’re probably pleasantly surprised, if not completely relieved! But keep in mind, if you ONLY pay off the INTEREST each month, you’ll be paying it every month indefinitely. Here’s a visual.

Fortunately, most credit card companies require you to pay more than just the interest each month. So you’re not likely to be strapped to your debt by a life sentence. Minimum payments, however, aren’t much better than interest-only payments.

The danger in minimum payments

On your bank statement you’ll see when your next payment is due and the minimum amount required. This amount is often quite small compared to the balance you owe, usually only 3%. Should you pay less than the minimum requirement your credit card company will start dishing out consequences, the first of which usually being a hike in your APR. Making minimum payments can be helpful when you are in a tight spot financially, but it won’t dig you out of debt very quickly. Your statement likely includes a minimum payment timeline, or the length of time it will take you to pay off the balance if you only make minimum payments.

What does this look like in the real world?

According to the credit agency TransUnion, the average Canadian has credit card debt amounting to $4,154. According to this government of Canada credit card payment calculator, if you were to make only minimum payments of $124.62 on this amount of debt, it would take you 19 years and 9 months to completely pay it off. Kind of like Andy Dufresne digging his way out of Shawshank with a rock hammer. Take a look at your own credit card statement to see what your prison sentence is.

If you were to have a child the same day you took on $4,154 in credit card debt, not only would your theoretical offspring have moved out by the time you pay off your balance but you’ll also have paid $4,927.59 in interest. That’s more than the original balance and an effective interest rate of 118.62%! Obviously, minimum payments should always be used as a temporary method of debt management.

Note: If you are not receiving a credit card statement in the mail each month then you are likely receiving an electronic statement. If you aren’t receiving an electronic notification then we recommend signing in to your bank account online and looking for your statements there. Or check in to your local branch and ask for details. It’s also a good idea to review your statements each month for notifications, updates, and changes to the terms of your credit card. For example, your interest rate can jump significantly, especially if you’ve missed two or more payments in a row.

How is monthly credit card interest calculated?

The amount of interest you owe each month is calculated in 4 steps. Lets go back to our example of a $500 purchase and pretend you made another purchase of $100 on March 3rd, but no other purchases for the rest of the billing period (which we will pretend starts on the 1st of every month.)

  1. Calculate the average daily balance. This is done by adding up each daily balance of the billing period and dividing it by the number of days in that billing period.
    • (day 1 balance + day 2 balance + day 3 balance etc.) ÷ number of days in the billing period = average daily balance
    • Ex. (500 + 500 + 600 etc.) ÷ 31 = $593.55
    • Ex. OR ((500 × 2) + (600 × 29)) ÷ 31 = $593.55
  2. Calculate the average daily interest rate. The company finds this rate by dividing the card’s APR by the number of days in the year.
    • APR ÷ 365 = average daily interest rate
    • Ex. 19.99% ÷ 365 = 0.0547%
  3. Calculate the periodic interest rate. This is done by multiplying the average daily interest rate by the number of days in the billing period.
    • average daily interest rate × days in billing period = periodic interest rate
    • Ex. 0.0547% × 31 = 1.6957%
  4. Calculate the monthly interest payment. This amount is determined by multiplying the average daily balance by the periodic interest rate.
    1. average daily balance × periodic interest rate = monthly interest payment
    2. Ex. $593.55 × 1.6957% = $10.06

Based on these calculations you will owe $10.06 in interest for your billing period in March.

Other interest charges

As per your credit card agreement you will also be charged interest on cash advances and balance transfers. These types of charges do not have a grace period and are charged interest immediately, even if you pay it off the same day you made the charge. They are also charged a higher interest rate than your regular APR. To get the specifics on your credit card in particular, call your bank or the credit card company. A customer service phone number is usually found on the back of your card.

How to handle it

When you see the numbers laid out for you, it’s obvious that credit cards are best used for purchases you plan to pay in full before the end of the interest-free grace period. If you do end up carrying a balance it’s a better idea to pay it off using a line of credit. Lines of credit usually have much lower interest rates compared to credit cards.

If you have any questions about credit cards or debt consolidations, please reach out to us!