How Is Credit Card Interest Calculated?

If your credit card has an annual purchase rate of, say, 18%, that doesn’t mean you get charged 18% interest once a year. Depending on how you manage your account, your effective interest rate could be higher, or it could be lower. It could even be 0%. That’s because interest is calculated on a daily basis, not annually, and is charged only if you carry debt from month to month.

Knowing how credit card issuers calculate interest can help you understand the true cost of your debt.

How to calculate credit card interest

Calculating credit card interest is a three-step process. You can use an online calculator, but it’s good to know how to do it yourself. If you want to follow along, grab your credit card billing statement. You’ll need some information from it.

Convert annual rate to daily rate

Your interest rate is identified on your statement as the purchase rate per annum (p.a.). Your credit card issuer might refer to this as an annual percentage rate, or APR.

Since interest is calculated on a daily basis, you’ll need to convert the purchase rate to a daily rate. Do that by dividing by 365. Some banks divide by 360; for our purposes, the difference isn’t worth worrying about, as it changes the outcome by only a hair. The result is called the periodic interest rate, or sometimes the daily periodic rate.

Determine your average daily balance

Your statement will tell you which days are included in the billing period. Your interest charge depends on your balance on each of those days.

You start with your unpaid balance — the amount carried over from the previous month. When you make a purchase, the balance goes up; when you make a payment, it goes down. Using the transaction information on your statement, go through the billing period, day by day, and write down each day’s balance.

Once you’ve got that done, add up all the daily balances and then divide by the number of days in the billing period. The result is your average daily balance.

Put it all together

The final step is to multiply your average daily balance by your daily rate, and then multiply that result by the number of days in the billing period.

Depending on whether your issuer compounds interest daily or monthly, your actual interest charge might differ slightly from this calculated amount. Compounding is the process of adding the accrued interest to your unpaid balance so that you are paying interest on interest.

Compounding is the reason you could pay more than your annual purchase rate in interest. For example, say your average daily balance was exactly $1,000 for the entire year. If the bank had an 18% interest charge just once at the end of the year, you’d pay $180. But since your interest compounds, you’d actually be on the hook for something closer to $195.

Getting your first credit card?

Whether you’re a beginner or a credit card pro, make sure you know how to handle a credit card responsibly. It’ll save you time, money and frustration.

How does credit card interest work?

Credit card issuers charge interest on purchases only if you carry a balance from one month to the next. If you pay your balance in full every month, your interest rate is irrelevant, because you don’t get charged interest at all. Obviously, paying in full is the most cost-effective way to go, but if you usually carry a balance, a low-interest credit card can save you money on interest.

Seeing the calculation in action points you to a quick way to reduce your interest charges: Pay twice a month, or more frequently, rather than once. That extra payment will shrink your average daily balance and, in turn, your interest. Say you have a $2,000 balance and will have $1,000 to put toward your credit card bill. If you paid $1,000 on the 20th day of a 30-day billing period, your average daily balance would be about $1,666. But if you paid $500 on Day 10 and $500 on Day 20, your average daily balance would be $1,500. You’d reduce your interest charge by about 10%.

Depending on your card, you might have different APRs for different kinds of transactions, such as purchases, balance transfers, cash advances and credit card repayment instalment plans.

How do card issuers determine interest rates?

The average credit card interest rate is 19.94%, according to the Reserve Bank of Australia. It hasn’t changed since late 2019.

Most credit cards have a single purchase rate for all customers. Some have a special introductory rate, and then an ongoing rate that kicks in after a certain period of time. The rates themselves are usually tied to the benchmark rate, which is the interest rate banks charge their biggest customers. When the benchmark rate goes up, credit card rates typically follow with an equal increase.

The type of credit card can also influence the annual purchase rate. Rewards credit cards tend to come with higher interest rates.

How can I lower my credit card’s interest rate?

You have control over some of the factors that determine your credit card’s interest rate. A better credit score gets you better credit card options. And if your score has improved significantly, you can try asking the issuer for a lower rate.

But regardless of the stated purchase rate on your card, you can reduce the effective rate in several ways: