How is Credit Card Interest Calculated?

Credit Card Interest with many cards

Interest rates and credit cards have a powerful — and potentially explosive — relationship in the U.S. economy.

Interest rates are the economic fuel that makes credit card companies so profitable. It allows them to almost casually extend loans every day to the 189 million Americans who own at least one credit card.

Interest rates are also the price consumers pay for the privilege of borrowing money — with certain spending limits — and make purchases whenever the mood strikes them.

The two can be a dangerous mix.

Credit card debt took a two-year nosedive starting in September of 2008 thanks to the Great Recession. Since then, card debt has grown steadily to what the Federal Reserve Board says is a record $1.027 trillion in March of 2018.

Credit card companies make a sizable amount of money off the interest on unpaid balances. Visa, the largest credit card company, had a record 51.87% profit margin on sales revenue of $18.36-billion in 2017. MasterCard, the next biggest credit card company, had a 41.68% profit margin on sales revenue of $12.5-billion.

The average interest on those unpaid balances in 2017 was 16.73%, but cardholders who don’t pay off the balance at the end of every month face rates in the 25%-and-higher range.

So obviously, if you’re using credit cards — and not paying off the balance at the end of each month — you should learn how interest rates work and how they affect your bill.

Calculating APR: A Step-by-Step Approach

How do you calculate credit card interest? Ah, the magic question. Here’s the answer — in step-by-step fashion that may remind you of your high school math class:

Steps to calculate credit card interest:
  1. Look Up the APR on Your Credit Card: The interest rate (known as APR) you pay on your credit card is part of your monthly bill. It is calculated on a daily basis, so your APR must be converted to a daily rate. The math equation for that is annual percentage rate (APR) ÷ 365 (number of days in the year). Let’s say your APR is 16%. OK, so we go 0.16 (your APR) ÷ by 365. That gives us a daily periodic rate of 0.00044.
  2. Calculate Your Average Daily Balance: Interest is assessed on your average daily balance. The math on that is total billing amount ÷ number of days in billing cycle. To figure that out, look back at your statement. Start with the unpaid balance (the amount of money carried over from the previous month’s statement). Add up each debit entry and divide it by the number of days in your credit card’s billing period. That’s the average daily balance.
  3. Multiply Your Daily Periodic Rate by the Average Daily Balance: The math on this one is daily period rate times x average daily balance. Let’s say your average daily balance was $1,200. So, we go 0.00044 (daily periodic rate) x $1,200 (average daily balance) and that equals $0.53.
  4. Multiply by the Number of Days in Your Billing Cycle: If it’s a 30-day billing cycle, that’s $0.53 multiplied by 30 and it equals $15.90. So, you will be charged $15.90 in interest for this billing cycle.

Factors That Determine Interest Rates

Interest rates can come in all sizes, but for credit cards they generally fall into one of three categories: variable rate, fixed rate and promotional rate. Most companies issue cards tied to revolving credit. Users of these cards are allowed to carry a balance on their accounts at the end of every billing cycle. Cardholders who carry a balance will see an interest charge on their next bill.

There are four major credit card companies — Visa, MasterCard, American Express and Discover — and several factors that go into the interest rate charged on each of their cards.

Among the factors:
  • Prevailing interest rates – Also known as “prime rates,” these provide the basis for most credit card rates. Prime rates were flat for years, but went up 0.25% in December 2015 and credit card interest rates went up with them. Cardholders paid an estimated $192 million more per month in interest based on that small change in the prime rate.
  • User’s credit history and card issuer’s risk evaluation – Credit card companies will look at both your credit report and your credit score to help them determine the interest rate you will be charged. High credit scores mean lower interest rates and vice-versa.
  • Different rates apply – The popular term for calculating interest is APR (or annual percentage rate), but a single card may have several APRs attached to it. There could be different APRs applied to purchases, cash advances, balance transfers and promotion rates. Some cards have APRs that change after six months or one year.  Most have variable APRs, but a few are fixed.
  • Promotional offers – Card companies will entice consumers with offers of zero-percent interest, sometimes for more than one year. When the promotional period ends, rates go up.
  • Payment history – If you are late with payments or fail to pay altogether, card companies will increase your interest rates, sometimes dramatically.

Variable, Fixed and Promotional Rates

Officially, there are 3 types of interest rates for credit cards — variable, fixed and promotional. Realistically, however, there is only one. They are all variable to one degree or another.

Some credit cards may start out with fixed and promotional rates, but inevitably those rates change, effectively becoming variable.

Nonetheless, you may choose to start with either or fixed or promotional rate because it suits your goals. Here is a review of the pros and cons for all three:

Variable Interest Rates

Variable-rate plans have their interest charges based on benchmarks such as the prime interest rate, interest on U.S. Treasury Bills, the Federal Reserve Discount Rate or other indexes. The card company takes that rate and adds several percentage points (i.e. “a margin”) to come up with the rate it will charge you.  When rates are low — as they have been recently — this is the way to go.

For example, the prime rate in the summer of 2018 is 4.75 percentage points. The card issuer adds a margin of 10-12 points for customers with good credit to come up with an APR of 14.75-16.75 percentage points. The margin is much higher (23-26 points) for those with bad credit, who will pay 27.75-30.75 percentage points.

As the name implies, variable interest rates change at any time, increasing or decreasing based on the index on which they are built. In some cases, there is a cap on how high or low a variable interest rate can go, but card companies do not have to give you notice that the variable rate will be changing.

And be aware that one late payment — whether for credit cards, mortgage or any other debt — could appear on your credit report and result in your APR going up.

Fixed Interest Rates

A fixed-rate card cannot change unless the card issuer gives the cardholder a 45-day notice. Cardholders either accept the change or decide not to use the card at the newer rate. Fixed rates are generally higher than variable rates, with the consumer paying a premium for the card’s relative stability.

Fixed-rate card companies also can change rates if:
  • You are more than 60 days late with payment
  • You completed a debt management program
  • You had a promotional fixed rate that has ended

The advantage of a fixed rate is that it’s stable. The card company must specify how long that rate will be fixed, and give you a 45-day notice when it will change the rate.

Promotional Interest Rates

Promotional interest rates usually are offered for a specified time and for specific uses. If you carry a balance on your credit cards, many cards will offer a zero-dollar balance transfer fee that can definitely help reduce the interest you pay.

Some cards offer a cash bonus if you spend a specified amount in a specified time. Other promotional offers include zero-percent interest on purchases for as long as 18 months or 10% off an item purchased from the retailer offering you a card.

These are all beneficial as long as you read the fine print. This is what tells you how long the promotion lasts and what the penalties are for late payment when that deadline passes.

For example, cards that offer zero-percent interest for 12 months require the balance to be completely paid off at the end of 12 months — otherwise, interest rates kick in immediately. There also could be interest charges for payments that are missed or less than the minimum payment due during the 12-month period.

There is another disadvantage of opening an account for a promotional offer: it could affect your credit score negatively because of the increased risk to lenders.

Overall, analysts suggest consumers be wary of promotional offers. Read the conditions closely, and be sure to set reminders when deadlines approach.

Different Rates

Keep in mind that separate interest rates and charges can apply to the cardholder’s cash advance balance and balance transfer. In fact, some credit cards impose a higher interest rate when cardholders fail to make payments.

For cash advance transactions, a flat fee or percentage could be added, putting an extra price on a convenient way to get your money. The cash advance fee is typically a percentage of the amount withdrawn — let’s say 5% on a $100 withdrawal — but that interest rate is generally higher than the standard purchase rate.

Interest starts accruing immediately on cash advances, so this type of withdrawal should be used only in emergencies. If you need a cash advance, pay off the balance as quickly as possible to reduce that high-interest balance.

For balance transfer transactions, read the terms and conditions very carefully. Many credit card companies charge a fee anywhere between 1% and 5% of the total amount transferred. Even after the introductory period of 0% interest (usually on the balance transferred, not new purchases), it immediately skyrockets to 20% or more. Of course, it’s always best to find a credit card with no balance transfer fee.

Rewards Cards have Higher Rates

Pay particular attention to the average percentage rate (APR) when you’re filling out a credit card application. Some credit cards have a single purchase APR for all customers. What is a good credit card interest rate? Most have a range — let’s say, 13% to 23% — depending on your creditworthiness. Those rates are generally tied to the prime rate (which is the interest rate that banks charge their biggest customers).

Keep in mind that rewards credit cards — the kind with points or cash-back offers — generally come with higher interest rates. Make sure the benefits outweigh the risks.

Interest Rates and Debt to Income Ratio

Card issuers offer different interest rates to borrowers because of the differences in each financial profile. One metric used to measure a borrower’s ability to repay is the Debt to Income Ratio (or DTI). The DTI is calculated by adding up a card applicant’s outstanding obligations and then dividing by his or her income.

The resulting percentage is used to estimate the potential default (or loss rate) to the lender for borrowers with similar DTIs. The card’s interest rate is a reflection of that risk factor. The greater the risk, the higher the interest rate.

While individual borrowers may differ on their ability to repay credit, card issuers also rely on the concept that borrowers with similar credit scores will tend to exhibit similar payment behavior. For example, the lower a person’s credit score, the more likely that he or she may default on a loan, thus the interest rate would be higher.

Avoiding Interest

There is really no secret to avoiding interest payments on credit cards. Pay off the balance every month and there never will be an interest charge. Unfortunately, that is not how most people handle their credit cards.

Depending on who’s survey you believe, the number of card holders in the U.S. who carry a balance from month-to-month ranges anywhere from 35% to 65%. Either way you look at it, that’s a bunch of debt and that means a bunch of consumers are subject to interest charges every time they look at their bill.

There are some short-term ways to avoid interest:
  • Set up an online account at your bank to automatically pay your credit card balance from your existing checking or savings account. This presumes, of course, that you have enough money in your bank account to handle the monthly credit card bills.
  • Find a promotional card offer for zero-percent interest. These usually have a time limit — 12-18 months is normal — during which you can carry a balance without penalty, but as soon as the time limit expires, a high interest rate kicks in.
  • Get a credit card with a grace period. A grace period is a time frame during which you can pay your credit card off without having to pay interest. Not all credit cards have a grace period, but the Credit Card Accountability Responsibility and Disclosure Act of 2009 (or Credit CARD Act) mandates that those that do should allow for at least 21 days. Grace periods usually only apply to purchases; they don’t apply to cash advances or balance transfers.

Long term, however, the only guaranteed way to avoid paying interest is to pay off the balance on all credit cards every month.

Lowering Interest Rates

Lowering the interest rate on your credit card account may not be as difficult as you might expect.

A 2014 survey by CreditCards.com found that 65% of the people who asked their credit card company for a lower interest rate got it. The problem is that only 23% of the 983 cardholders surveyed even bothered to ask!

If asking strikes you as being a little too forward, there are other steps to get your interest rate reduced:
  • Be aggressive and on-time with payments. If your credit report shows that you make regular payments in a timely fashion and pay down as much debt as you can afford each month, card companies will be encouraged to reward you.
  • Check your credit score and negotiate. If you have a good credit score, most companies will want to do business with you. Compare your card with other credit cards. The credit card industry is fiercely competitive. If you receive offers from other companies via mail, compare it to the rates you pay, and then call your card company to ask them to beat the offer.
  • Loyalty helps. If you have been with a card company for five years or longer use that in the negotiation process. They don’t want to lose your business.
  • Ask a credit counselor for help. Non-profit counseling agencies can assist in getting your interest rate reduced and make it easier to pay off the card balance through a Debt Management Plan (DMP). You could see your interest rate drop under 10% and lower with a good DMP.

When you comparison shop, be sure that you’re matching apples to apples. Annual fees, late fees, balance transfer fees and rewards should be identical or very close.

And for the record, 86% of the people in the CreditCards.com survey who asked for a late payment fee waiver also received it.

Other Ways to Decrease Rates

There are other ways to decrease — or even eliminate — the interest rates on credit card purchases.

Pay Your Bill Early: Credit cards generally offer a grace period (usually 25 to 30 days) where you won’t be charged interest on your purchases. If you pay the bill in full before the due date, you could avoid paying interest altogether.

Pay More Than Once a Month: If you make bi-weekly payments, for example, you can drastically cut the interest charges. How could this work? Let’s say you have a $2,000 balance and you have $1,000 for a payment. If you paid $1,000 on the 20th day of a 30-day billing period, the average daily balance would be about $1,633. But if you paid $500 on Day 10 and $500 on Day 20, the average daily balance would be $1,467 (or about 10% less in interest).

Pay More Than the Minimum: Even a small uptick in the payment can save plenty in interest charges.

Only Charge What You Can Afford: If you use the credit card for convenience and not credit — buying things you would normally pay for with available cash — you never have to worry about overspending. You can pay off the bill and not be saddled with interest charges. It might help to carry a notebook in your pocket and keep track of your purchases to assure you’re staying on course.

Current Credit Card Usage

As of 2017, an estimated 189 million Americans have at least one credit card and use it often to make retail purchases and pay bills. About 18% of the cardholders carry 3-4 cards, 9% carry 5-6 cards and 7% carry seven or more cards.

The Federal Reserve Board says the amount of revolving debt on those millions of cards was $1.027-trillion as of March 2018 and the average APR on cards with a balance is 16.73%. That means that credit card interest payments make up a significant portion of the national economy.

Credit card issuers compete with one another to attract customers with an array of perks and bonuses. With reward plans, cash back programs and variable fee structures that abound, a savvy consumer should shop around. However, a card’s interest rate is still the most significant barometer of its ultimate value to its issuer and thus the highest potential expense for the user who doesn’t pay the balance off completely every month.

Bill Fay

Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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