So your bank tells you your credit card has an APR of 14%, or 18%, or 22%. What does that actually mean? How does your bank calculate your interest rate, and how does that translate into how much you actually pay? Here’s how it works.
If you have a taste for jargon, check out your credit card billing statement. There’s a lot to look at there, but for this calculation the two important numbers are your balance and your APR, or annual percentage rate. As an example, let’s say that in your most recent billing period, you started with a balance of $2,500, and your APR is 14%.
Although interest is usually expressed as an annual rate, interest is actually charged on a daily basis.
1. Convert annual rate to daily rate
“Annual percentage rate” is a little misleading. As you know, you don’t get charged interest on your balance once a year. Interest is actually charged daily. To find out your daily rate, divide your APR by 365. (Some banks divide by 360; for our purposes, the difference isn’t worth worrying about.) In our example, 14% divided by 365 is 0.038% 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 starts with 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 $2,500 balance for the first 10 days that it accrues interest. On day 16, you pay $600. Add up your daily balances:
(15 x $2,500) + (15 x $1,900) = $66,000
Then divide by the number of days in the month to get your average daily balance:
$66,000 / 30 days = $2,200.
The key takeaway here is that the longer you take to pay off your balance, the more interest you’ll be charged. Pay earlier — or, better yet, make an extra payment — and you’ll pay less in interest.
3. Put it all together
Finally, to figure out your interest charge for the next month, multiply your average daily balance by your daily rate and the number of days in the month:
$2,200 x 0.038% x 30 = $25.08
Your total may be slightly different depending on whether the issuer compounds interest daily or monthly. Compounding is the process of adding the accrued interest into your unpaid balance, so that you are paying interest on interest. Compounding is the reason you could pay more than 14% in interest when your APR is 14%. For example, say your average daily balance was exactly $1,000 for the entire year. If the bank had a 14% interest charge just once at the end of the year, you’d pay $140. But since your interest compounds, you’d actually be the hook for something like $150.
What determines my 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 APRs, 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.