How Credit Card Calculates Interest

In Canada, credit card company uses mainly two methods to calculate the interest you pay. The methods are, average daily balance method and daily balance method. Although the methods are different, they generate same interest charge. If you are interested finding out which method your card uses, you can call their 800 number or you can find it in your credit card agreement brochure. Now let’s look at these two methods.

Average Daily Balance Method

Your credit card has billing period of 29 to 31 days. Average daily balance is just the average of you daily balance during your billing period. Average daily balance is calculated at the end of every month. Take the balance at the end of every day and add them up (A). Divide this total (A) by the number of days in your billing cycle to get average daily balance (B). B is multiplied by daily interest rate to get average daily interest amount(C). Now, to calculate interest charge for the month, multiply C by the number of days in the billing period.

To get daily interest rate, take annual interest rate and divide by 365. Also, interest rate can be found on your monthly statement.

Daily Balance Method

This method is simpler than average daily balance method. Instead of making one calculation at the month end, daily balance method calculates your interest at the end of every day of the billing period. Calculation method is simple. Take your daily balance and multiply that by the daily interest rate and add up daily interest to obtain interest for the month.

Purchases, Cash Advances and Balance Transfers

If you pay your balance in full, you never pay any interest. If you don’t pay your balance in full, you’re charged interest from the date you made these purchases until they’re paid for in full. Some credit card issuers charge interest from the date the purchases are posted to your account. You’re charged interest from the date you made the cash advance or balance transfer.

Let Your Credit Card Company Pay Your Interest

By paying you balance every month in full, you are actually using your card company’s money for free for your full billing period. Your card company always wants you to carry a balance so they can charge you interest and that’s how card companies make money. If you are paying your balance in full, you a re actually using your card company’s money at their high interest rate for free. Let me give you an example. In Sep 2006, I bought five British Airways return tickets for my trip at approximately $2000 each. My total cost was $2000 * 5 = $10,000. Most of the card companies charge 20% annual interest rate. If I do an approximate calculation for $10,000 at 20%, my one month interest charge would be $165. Yes, that’s right. My one month interest charge would have been $165. But I avoided this charge by paying my balance in full and definitely my card company did not like it because they lost $165. If you look at this little differently, you can say that I borrowed money for one month at 20% interest rate but I have not paid any interest because my credit card company paid it for me.

What do all these translate into? Know how you are being charged and what your interest rate is. Pay your balance in full. It’s like using your card company’s money at their expense.

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This entry was posted on Sunday, December 21st, 2008 at 5:42 pm and is filed under Credit Cards, Featured. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.