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Knowing How Credit Card Interest Is Calculated Can Save You Money

Dec. 22, 2014
Credit Cards
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If you can’t pay off your entire credit card balance, you need to know how your credit card interest is calculated and how to minimize it. Read on to learn about average daily balance and strategies to lower your accrued interest this month.

Credit card interest calculated: Let’s do the math

Here’s the scenario: You hate credit card debt and never spend more than you can afford to pay off before the due date. But an emergency comes along. You realize you’re going to be short on your credit card payment by $300. No big deal, right? That’s only $4.50 in interest, using an 18% interest rate and 360-day formula. But then you discover you’ve been charged way more than that and you aren’t sure why.

The $4.50 figure would be correct if you accrued interest on the balance remaining at the end of the month — the $300. But that’s not how credit card interest is calculated. It’s calculated on the average daily balance. Here’s the math:

Let’s assume a 30-day month and a total monthly balance of $2,000. You make your payment of $1,700 five days before the due date, leaving a daily balance of $2,000 for 25 days and $300 for 5 days.

Average daily balance = (2,000 x 25) + (300 x 5) = 51,500 / 30 = $1,717

Daily interest rate = 18% / 360 = 0.0005 (Keep in mind, some issuers use 365 instead of 360.)

Interest charge for the month = 1,717 x 0.0005 x 30 = $25.75

That’s $21.25 higher than if your interest was calculated based on your remaining balance at the end of the month. It may not seem fair, but that’s how it works.

What strategies can I use to reduce my interest payment?

The lower your average daily balance, the lower the amount of interest you’ll pay. You can lower your average daily balance by making frequent payments, instead of one on or before your due date. So if you’re paid twice a month — 25 days and 10 days before your due date — make a payment of as much as you can afford without jeopardizing the rest of your bills on both of those dates.

If your savings account has a little extra padding, you can pull money from it to cover the shortfall. You should not drain your emergency fund, but if you have a surplus, you should use it to pay off the rest of your credit card balance.

It’s also a good idea to reduce expenses and earn extra money during this time. Here are a few ideas on how to make more and spend less in order to pay off your credit card.

The takeaway: Your credit card interest is calculated based on your average daily balance, not your remaining balance at the end of the billing cycle. If you can’t pay off your entire balance this month, make multiple payments throughout the month to lower your average daily balance. Also, consider pulling some money from your savings to cover the discrepancy or work to make more or spend less this month.

Image via iStock.