In normal layman’s terms – the interest is calculated on a daily basis using the APR rate – multiplied against the amount outstanding on the card. This is summed up each month and added as a charge.

Daily Rate (%) x Average Daily Balance x Number of Days In Month

The first thing to understand about credit card interest is the terminology. The three key definitions that you need to know are outlined below:

1. APR: This is the ‘Annual Percentage Rate’, which is how much interest is charged per year (or ‘per annum’ – the ‘p.a’. that comes after advertised interest rate).
2. Daily Rate: This is the APR on the card divided by 365 days.
3. Average Daily Balance: The average balance in your account for a month. You can work it out by adding up your balance on each day and divide by the number of days in the month.

This is the most accurate way to figure out your interest because, if you just went off the APR you would be looking at a flat monthly rate of $14.16 that would not reflect any significant changes in your daily balance or the days in each month. Now it is a matter of seeing how these elements work with an actual credit card. Below is an example;

Monthly Interest Calculation Example

Say you had a credit card with an interest rate of 17% p.a. – (your APR)  in this scenario – and an average monthly balance of $1,000.

The daily rate for this APR of 17% is divided by 365 days = 0.0465%.

To work out your interest for the month, you would simply use the following equation as mentioned above:

Daily Rate (%) x Average Daily Balance x Number of Days In Month

0.0465%  x  $1,000  x 30   = $13.95  (a 30 day month in this scenario)

0.0465%  x  $1,000  x 30   = $14.42  (a 31 day month in this scenario)

Interest charged on $1,000 balance over 12 months

Remember that each month any interest charged will be added to your total outstanding balance, so if you don’t pay it off each month it will cost more and more in interest charges each month. The below example shows the interest charges based on 17% p.a. while making just the minimum required payment of 2%.  At the end of a 12 month period there is still $1,059.85 balance outstanding despite paying $99.68 in interest charges as the interest has been added to the monthly balance. (Calculations are an example only). 

The main complications with credit cards come with applying this thinking to the statement periods of your card and any interest free days available.  If you don’t understand those, take a look at this post on how interest free days work.

Different Types Of Credit Card Interest

So you’ve found the best credit card for you, as well as these terms, you need be aware of the different types of interest rates that apply to your credit card, including:

• Purchase rate: This rate is applied to new purchases made on your credit card and is e most commonly referred to interest rate.
• Cash Advance Rate: This rate of interest is applied to cash advance transactions and has an APR that is typically higher than the purchase rate (usually around 21% p.a.)
• Balance Transfer Rate: This rate of interest is charged for balances transferred onto the credit card. It is usually either the purchase rate or the cash advance rate.
• Introductory Interest Rate: Many credit cards offer lower interest rates when you first sign up. These rates apply only for a limited amount of time and are often seen as balance transfer offers, such as 0% for nine months.

The type of interest rate applied to your card balance can make a huge difference to how much you pay each month and throughout the year. The following table helps put things into perspective for a 30-day month:

In this scenario the balance transfer rate is the same as the purchase rate, but it is worth noting that the cash advance rate is often applied to balances after the introductory period has ended.

So while the question whether the purchase rate or cash advance rate applies to your balance may seem minor when you are considering a balance transfer option, it can make a huge difference.

While credit card interest rates are often taken at face value, looking at how interest is calculated will give you a greater understanding of how your credit card works. In turn, that should help you find ways to make credit work better for you.

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