So your bank tells you that your credit card has a 15% APR. What does that actually mean? How does your bank calculate your interest rate, and how does that translate into how much you actually pay? We’ll demystify the mechanics of calculating your interest payments.
Annual percentage rate, daily interest rate, average daily balance … what?
If you like having tons of jargon thrown at you, check out your credit card billing statement. From two simple numbers (your statement balance and your APR) comes a less-than-intuitive calculation. Here’s how to figure out how much interest you actually owe. As an example, let’s say your last statement balance was $1,000, and your APR is 15%.
1. Go from annual percentage rate to periodic interest rate
“Annual percentage rate” is a little misleading. As you know, you don’t get charged interest on your balance once a year — actually, your interest is charged on a daily basis. To find out your daily rate, divide your APR by either 360 or 365. (Different banks use different numbers; we’ll use 365). In our example, 15% divided by 365 is 0.041% per day — not much, but it adds up. This number is called the periodic interest rate, or sometimes the daily periodic rate.
2. Determine your average daily balance
The amount of interest charged depends on your unpaid balance — the amount carried over from the previous month. However, you do get credit for paying off some of your balance early. To take that into account, a bank charges interest based on your average daily balance. As the name implies, this is the average amount of the unpaid balance over the course of the month.
For example, let’s say you don’t pay off any of your $1,000 balance for the first 10 days that it accrues interest. On day 11, you pay off $300, and on day 21, you pay off $500. Your average daily balance is (10 x $1,000 + 10 x $700 + 10 x $200)/30 = $633. The key takeaway? The longer you wait to pay off your balance, the more interest you’ll be charged.
3. Put it all together
Finally, to figure out your interest charge for the next month, multiply your average daily balance by your periodic (daily) interest rate, and multiply that by the number of days in the month. In our example, it’s $633 x 0.041% x 30 = $7.79.
Note that the amount of interest you pay is actually higher than your annual percentage rate. Let’s say that your average daily balance was exactly $1,000 for the entire year. If the bank had a 15% interest charge just once at the end of the year, you’d pay $150. But since your interest compounds — meaning, the interest gets added into your balance, and then you pay interest on that interest — you’re actually on the hook for more than $160.
How does the bank determine my interest rate in the first place?
Your credit card interest rate depends on a variety of factors, including your credit score, the type of card, and the type of lender. Lower credit scores usually mean higher rates; rewards and travel credit cards tend to have higher APR’s, while low interest and balance transfer cards have, well, low interest rates. In general, credit unions offer lower interest rates than banks.
If you want to lower your interest rate, the best thing to do is beef up your credit score. Make sure you pay off as much of your existing credit card balance as you can before you apply for a new card, and check out our credit score boot camp for more tips.