Credit cards. Everyone has one. Many have more than one. And we all know how quickly the debt can build up, especially with mounting interest. You probably know what the interest rate is on your credit card, but do you know how the interest is calculated?
When is interest owed?
One of the reasons consumers worry about using credit cards is because of the large amount of interest they expect to pay on top of the original purchase. But did you know that if you pay off the debt within 21 days of the purchase date you won’t have to pay any interest at all? This is called the grace period. This is good news, especially because the average credit card these days has an interest rate of 19.99% or more. That’s a high rate to pay on relatively small amounts of debt.
So, if you don’t pay interest amounts paid back within the grace period, when do you pay interest?
- when you carry forward a balance
- when you make a cash advance (withdrawing cash from your credit limit)
- when you make a balance transfer (moving debt from one credit card to another)
Annual Percentage Rate
If you take a look at your credit card statement you’ll find several bits of important information. There’s the list of your transactions of course, as well as your credit limit, your balance, payment due date, minimum payment amount, and your annual percentage rate (APR). This is the rate of interest you will pay if you carry a balance. (Interest rates on cash advances and balance transfer are usually much higher than your APR. Check your statement or contact your credit card company for details.) Having an Annual Percentage Rate doesn’t mean you pay interest once a year, but rather it refers to how much interest you would pay over the course of a year. Interest is calculated daily which means the credit card company takes your APR and divides it by 365 to find the daily interest rate. (Ex: 19.99% ÷ 365 = 0.05476712% charged daily.)
Along with your posted minimum payment required, you’ll also notice on your credit card statement a calculation based on minimum payments, usually 3% of your balance. This is a projected timeline based on making only minimum payments and shows you how long it will take you to pay off your balance (but only if you don’t add more debt). Depending on the size of your balance and interest rate, it could take you months, years, or even decades to pay off your balance using only minimum payments. Minimum payments are a boon when you’re temporarily tight for cash, but they are not an effective way to pay down debt.
Real World Example
The average Canadian, according to the credit agency TransUnion, holds $4,154 in credit card debt. Using this government of Canada debt payment calculator, it would take said average Canadian 19 years and 9 months to pay off their credit card debt making minimum payments of $124.62. This kind of payment plan is akin to Andy Dufresne digging his way out of Shawshank with a tiny little rock hammer. Take a look at your statement to get an idea of what your prison sentence looks like. The difference is that you (most likely) aren’t limited to teeny tiny payments. The government calculator also shows us that by the time the debt is paid off, you’ll have paid $4,927.59 in interest. That’s more than the original debt and effectively an interest rate of 118.62%! When your future is laid out like this, it’s very easy to see that credit card debt is no joke and that minimum payments are definitely not the way to go.
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.
Calculating Monthly Interest Charges
Credit card companies calculated the interest you owe in four steps. Lets say your pay cycle starts on the first of each month and that you start this cycle with a balance of zero. On March 1st you make a purchase of $500, a purchase of $100 on the 3rd, and no other purchases or payments for the rest of the month. (Note that these calculations do not include amounts that are repaid within the grace period.)
- 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
- 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%
- 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%
- Calculate the monthly interest payment. This amount is determined by multiplying the average daily balance by the periodic interest rate.
- average daily balance × periodic interest rate = monthly interest payment
- Ex. $593.55 × 1.6957% = $10.06
We can see based on these calculations that you will pay interest in the amount of $10.06 for the pay period starting on March 1st if you do not make any payments during the grace period.
As mentioned earlier, you will also accumulate interest charges on cash advances as well as balance transfers. These types of charges do not have an interest-free grace period and accumulate interest immediately, even if you pay it back the same day of the transaction. The interest rates on these kinds of transaction is higher than your APR. To get more details, refer to your credit card statement or contact your credit card provider using the phone number on the back of your card.
What To Do
When you see it all laid out it’s obvious why so many people are wary of credit card debt. It can accumulate quickly and take a lifetime to pay off. Credit card debt is best paid for within the interest-free grace period and balances carried over should only be kept short-term. If you anticipate carrying a balance longer than a couple of months we advise you to consider a line of credit instead. This kind of product carries a much lower interest rate. To find out more contact us today.