Many consumers use credit cards to help build their credit profiles. This can be a great way to build a credit history, but it’s important to be careful. Negative information in your credit report —such as late payments or irresponsible use of credit—can result in a lower credit score, debt, and financial difficulty.
To avoid getting in over your head, it’s important to understand how credit card interest is calculated. Otherwise, what seems like a small balance could spiral out of control.
How can you calculate your total monthly interest?
There are generally three things cardholders must know in order to calculate their total monthly interest:
- Annual percentage rate (APR)
- Daily periodic interest rate (DPR)
- Average daily balance (ADB)
It’s important to note that the methods credit card companies use to calculate and compound interest vary. Investigate your credit card agreement for more specific details.
Annual percentage rate (APR). In early January 2014, the average annual percentage rate (APR) was 13.02 percent for fixed-rate cards and 15.37 percent for variable-rate cards. Look closely at your billing statements to find your card’s APR.
Since the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act, which passed in 2010 and reformed the credit card market, many issuers offer variable rate credit cards. Rates on these cards fluctuate based on an index, so you may see your rate rise (or fall) over the course of a year.
Your interest rate may also increase as a penalty for making a payment that was late or returned.
Generally, credit card interest rates are different for purchases, writing checks from your credit account, and withdrawing cash, with cash advances and balance transfers usually having higher APRs.
Thoroughly review your credit card statement. It must clearly list each APR category and its outstanding balance.
Daily periodic interest rate (DPR). The daily periodic interest rate (DPR) is how much you pay in interest each day, based on each day’s balance.
Most billing statements have already calculated the DPR for you and provide it in your rate summary. However, if you want to calculate your rate, first review your credit card statement to find out whether your creditor calculates your DPR using 360 or 365 days. Then, divide your APR by 360 or 365 (depending on the terms of your credit card) to get your DPR.
Average daily balance (ADB). Many creditors use the average daily balance (ADB) method to calculate interest, which means interest accrues daily. Your creditor should determine your ADB for you on your billing statement, but knowing how to figure it out yourself will help you ensure you’re being charged the correct amount.
To calculate the ADB, add together the balances for each day of the month, then divide that number by the number of days in the billing period (usually 30 days).
Once you have both your DPR and your ADB, you can calculate how much you owe in interest. Simply multiply your ADB by your DPR, and then multiply that answer by the number of days in the month.
Getting out of debt: Pay more than the minimum
Credit card interest compounds, which means that when you fail to pay off a balance and are charged interest, you pay interest on the new balance that includes the interest previously charged. This can make it hard to get out of credit card debt when you’re just paying the minimum balance each month.
For example, if you have a balance of $1,280 and make only minimum payments, it will take you seven years to pay off the balance—assuming you don’t charge any more—and you will wind up paying more than $2,100.
On the other hand, if for example, you pay roughly $45 each month, it will take you approximately three years to pay off that same debt. You’ll still spend around $1,622 to pay off the debt, but that’s nearly $480 less than you’d spend making only the minimum payment.
If you’re not in debt, pay off your balances each month. If you’re already in debt, don’t worry—it is possible to get out. Make a budget and stick to it, and pay more than your minimum balance each month. Eventually, you’ll be living debt free.