If you have a credit card you probably have a good idea what your interest rate it. But how does that interest rate work? How does the credit card company calculate how much interest you will pay? And when is it calculated?

When do you pay interest?

You might be surprised to know that just because you use a credit card doesn’t mean you HAVE to pay interest on your purchases. If you pay off what you owe within 21 days of the purchase date you will NOT have to pay any interest! This interest-free time is known as the grace period. This is excellent news for those who worry about paying to borrow money, especially if their interest rate is very high. (Some cards can carry an interest rate of 24.99% or even higher! Insert horrified emoji here.) Plus, if you have a credit card that offers rewards like cash back or travel points, you’ll get the added benefit of those perks.

But what if you don’t pay what you owe within the grade period? This is when interest starts to accumulate. This can happen on several types of transactions:

  • balances carried over
  • cash advances (withdrawing or transferring cash from your credit card)
  • balance transfers (moving debt from one credit card to another)

Annual Percentage Rate

The annual percentage rate (APR) is the interest rate on your card. You can find this amount on your credit card statement along with other details about your card such as your credit card limit, payment due date, minimum payment amount, and available balance. The APR is the rate of interest you will be charged on balances carried over from one statement to the next. (Cash advances and balance transfers often run at different higher rates.) The word “annual” may sound like you’ll only be charged interest once a year, but we all know that isn’t true. The APR is actually divided between every day of the year.

For example, lets say you have a credit card with an APR of 19.99%. Take that number and divide it by 365 and you’ll get the percentage of interest you will be charged each day. 19.99% ÷ 365 = 0.05476712% interest charged per day. (More on this later.)

The danger of minimum payments

As mentioned earlier, on your statement you will see your minimum payment information. This is usually calculated at 3% of your total balance. If you do not pay this minimum amount the credit card company will start dishing out consequences, the first of which usually being a huge jump in your APR. Being able to make just a minimum payment can be a huge help when you are temporarily strapped for cash, but it definitely shouldn’t be your intended repayment plan. You may also find on your statement a calculation on how long it will take you to pay off the balance of your card, with interest, should you ONLY make minimum payments. Depending on how much debt your credit card is carrying, this timeline can be months, years, or even decades!

Real world example

The average Canadian carries $4,154 in credit card debt, according to the credit agency TransUnion. Using this government of Canada debt repayment calculator we can see that making minimum payments of $124.62 on this amount of debt would take 19 years and 6 months to pay off completely. This sounds a little like Andy Dufresne breaking his way out of Shawshank with a tiny rock hammer. Take a look at your own credit card statement to get an idea of how long you could be digging your way out of debt by making minimum payments.

In this example, not only would you have paid off the original $4,154 debt, but you would have also paid $4,927.59 in interest. That’s more than the original balance and an effective interest rate of 118.62%! At this point we probably don’t need to further convince you that minimum payments are 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.

How is the interest calculated?

Interest is calculated in 4 steps. Say you make a $500 purchase on March 1st, the first day of your billing cycle, and a $100 purchase on March 3rd and no further purchases until a month or two later.

  1. Average daily balance. Calculate this 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. Average daily interest rate. The credit card company finds this rate by dividing your card’s APR by the number of days in the year.
    • APR ÷ 365 = average daily interest rate
    • Ex. 19.99% ÷ 365 = 0.0547%
  3. Periodic interest rate. This is calculated by multiplying the average daily interest rate by the number of days in the billing period.
    • average daily interest rate × days in the billing period = periodic interest rate
    • Ex. 0.0547% × 31 = 1.6957%
  4. 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

Using these calculations, if you started the billing cycle with a $0 balance, made $600 in purchases on the above specified dates, and did not pay off the balance until the payment due date, you would pay $10.06 in this billing cycle.

Other interest charges

You will also be charged interest on other transactions such as cash advances and balance transfers, as per your credit card agreement. These charges accumulate interest immediately because they do not have an interest free grace period, even if you pay it off the same day. These charges also have a higher interest rate than your APR. For more details on your specific rates please refer to your credit card statement or contact your credit card company. The toll-free customer service phone number is most often found on the back of your credit card.

Moving forward

With this information in mind it is clear that credit cards are best used for purchases you plan to pay off in the grace period or shortly thereafter. If you do anticipate carrying a balance it is better to transfer that debt to a line of credit because they have much lower interest rates.

For answers about credit cards, lines of credit, or debt consolidation, please call us today!