If your credit card has an annual interest rate of, say, 18%, that doesn’t mean you get charged 18% interest once a year. Depending on how you manage your balance and make payments, your effective interest rate could be higher or lower. It could even be 0%. That’s because interest is calculated on a daily basis, not annually, and is charged only if you carry a balance from month to month.
Knowing how credit card issuers calculate interest can help you understand the true cost of your debt.
How to calculate credit card interest
Calculating credit card interest is a three-step process. While some lenders may use different methods, here’s a general overview of how interest is typically applied. If you want to follow along, grab your credit card billing statement.
1. Convert annual rate to daily rate
Your interest rate is identified on your statement as the annual interest rate, or AIR, sometimes referred to as annual percentage rate, or APR.
Since interest is calculated on a daily basis, you’ll need to convert the AIR to a daily rate. In most years, you’ll do that by dividing it by 365; if it’s a leap year, divide by 366. Some banks divide by 360. For our purposes, the difference isn’t worth worrying about, as it changes the outcome by only a hair. The result is called the periodic interest rate, or sometimes the daily periodic rate.
» MORE: Does your credit card’s interest rate matter?
2. Determine your average daily balance
Your statement will tell you which days are included in the billing period. Your interest charge depends on your balance on each of those days.
Start with your unpaid balance — the amount carried over from the previous month. When you make a purchase, that balance goes up; when you make a payment, it goes down. Using the transaction information on your statement, go through the billing period, day by day, and write down each day’s balance. Using a spreadsheet will make the next step easier.
Once you’ve written down all your daily balances, add them all up, and then divide the sum by the number of days in the billing period. The result is your average daily balance.
3. Put it all together
The final step is to multiply your average daily balance by your daily interest rate, and then multiply that result by the number of days in the billing period.
Depending on whether your issuer compounds interest daily or monthly, the actual interest charge you see on your statement might differ slightly from the amount you calculated. Compounding is the process of adding the accrued interest into your unpaid balance so that you wind up paying interest on interest.
Compounding is the reason you could pay more than your AIR in interest. For example, say your average daily balance was exactly $1,000 for an entire year. If the bank had an 18% interest charge just once in December, you’d pay $180. But since your interest compounds throughout the year, you’d actually be the hook for closer to $195.
» MORE: What happens if I make only the minimum payment?
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How does credit card interest work?
Credit card issuers charge interest on purchases only if you carry a balance from one billing period to the next. If you pay your balance in full every month, the interest rate is irrelevant, because you won’t be charged interest at all. Obviously, paying in full is the most cost-effective way to go, but if you usually carry a balance, a low-interest credit card can help you save money on interest.
Seeing the calculation in action demonstrates a quick way to reduce your interest charges: Pay your credit card bill twice a month, or more frequently, rather than once. That extra payment will shrink your average daily balance and, in turn, your interest charges.
Say you have a $2,000 balance and will be able to pay $1,000 toward your credit card bill. If you paid $1,000 on the 20th day of a 30-day billing period, your average daily balance would be about $1,666.66. But if you paid $500 on Day 10 and $500 on Day 20, your average daily balance would be $1,500. Using the second strategy would reduce your interest charge by about 10%.
Depending on your card, you will likely have different interest rates for different kinds of transactions, such as purchases, balance transfers and cash advances. Your credit card agreement and statement will include the specific interest rates for different kinds of transactions.
How do card issuers determine interest rates?
Some credit cards have a single purchase AIR for all customers. Others advertise a range — for example, 13% to 23% — and assign you a specific rate based on your creditworthiness. The better your credit, the lower your rate. The rates and ranges themselves are usually tied to the prime rate, which is the interest rate banks charge their biggest customers. When the prime rate goes up, credit card interest rates typically follow it with an equal increase.
Interest rates can also vary based on the type of transaction — you might see 19% interest on regular purchases and 22% on cash-like transactions and cash advances.
The type of credit card you have can also influence the AIR. Specialized and retail credit cards tend to come with higher interest rates.
How can I lower my credit card’s interest rate?
You have control over some of the factors that determine your credit card’s interest rate. Having a better credit score gets you better credit card options. And if your score has improved significantly since you applied for your current credit card, you can try asking the issuer for a lower rate. But regardless of your card’s stated AIR, you can reduce your effective interest rate in several ways:
- Pay your bill in full every month, if possible, to avoid interest.
- If you can’t pay your bill in full, make more than the minimum payment.
- Make payments more than once a month to shrink your average daily balance.
Now that you understand how credit card interest works, you’re in a better position to take charge of it — and minimize how much you pay.
» MORE: When is the best time to pay my credit card bill?
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