How does credit card interest work?

We’re all kind of familiar with the basics, right?

A credit card can help build your credit score and earn rewards like points or cash back as long as it’s used responsibly, otherwise, it can be harmful and charge steep double-digit interest rates. It's the classic example of a double-edged sword.

But when does credit card interest kick in? And how is it actually calculated?

The truth is it can be downright confusing, and many Canadians are in the dark about the specifics¹. To help lift the veil, we’ve broken down exactly how credit card interest works below.

When does credit card interest enter the picture?

Roughly every 30 days, a statement arrives in your inbox or banking app with what can feel like an overload of information, including a list of all the purchases you made over the past month.

Arguably the three most-crucial pieces of info can be found near the top-right corner of the statement:

• Statement balance (or new balance)
  
• Minimum payment
  
• Payment due date
  
  

The statement balance is the total amount you’ve spent on the credit card. As long as you pay back the full balance on time by the payment due date, you won’t be on the hook for interest.

But, if you just make the minimum payment or pay any amount that’s less than the statement balance by the due date (even if it’s under by a few measly dollars), you’ll be borrowing money and effectively turning your credit card into a short-term loan. And like with any loan, interest will be part of the equation. Interest will continue to rack up on your credit card on a daily basis – on each and every purchase from the date you swiped your card - until your statement balance is paid back in full.

How is credit card interest calculated?

You’ve likely read the term APR on your credit card statement (or heard it mentioned in a car commercial while watching reruns). APR stands for annual percentage rate and it’s what banks use to calculate the amount of interest someone owes when borrowing money.

The typical credit card has an APR of 19.99%.

You might read the word “annual” and think interest is charged once per year but that’s not the case. APR is shown on an annual basis as a benchmark (kind of like how kilometers per hour is used to measure a car’s speed) but it’s actually calculated on a daily basis and charged monthly.

Here’s a simplified example of how credit card interest is calculated:

• Step 1: Divide the APR by 365, the number of days in a year
  
• E.g. A typical credit card with a 19.99% APR would have a daily interest rate of 0.055%
• Step 2: Multiply the daily interest rate by the average balance owed
  
• E.g. If you carry a $5,000 balance on a typical credit card, you’d owe $2.73 in interest after one day ($5,000 x 0.055%)
• Step 3: Multiply the daily interest payment by 30 to work out how much interest you’ll owe at the end of the 30-day monthly billing cycle.
• E.g. If you owe $5,000 over the course of the monthly billing cycle, you’d owe $81.9 in interest ($2.73 x 30) once your statement arrives. That would increase your new total balance to $5,081.90

In the real world, credit card balances rarely stay stagnant. Your balance will go up every time you swipe your card, and down any time you pay back your debt. As a result, banks use a calculation known as the daily balance method to account for the fluctuations. Banks do this by adding up the balance you owe at the end of each day and dividing the sum by the number of days in the billing cycle.

To avoid boring you too much, here’s what the formula would look like:

(Balance owed on Day 1 + Balance owed on Day 2….. + Balance owed on Day 30) ÷ 30, which is the total number of days in the typical billing cycle.

Different credit card rates

Everything covered above applies to interest owed on everyday credit card purchases, like groceries, food deliveries, or anywhere you swipe or key in your card number.

But, if you borrow money from your credit card by withdrawing cash from the ATM (aka a cash advance), you’ll owe a higher interest rate and rack up interest charges right away. There’s no payment due date or interest-free grace period with cash advances like with everyday credit card transactions.

How to reduce interest charges

Here are some helpful tips:

• Keep a budget, monitor your spending, and only use your credit card for purchases you can afford to pay in full (in other words, treat your credit card like a debit card not a loan).
  
• Can’t pay off your balance in full? Don’t settle for making just the minimum payment. The less of your balance you pay back, the more interest you’ll owe.
  
• Be proactive. If you pay back your credit card debt in multiple payments several times per month – instead of just waiting for your monthly statement to arrive - you can lower your average daily balance, and a result, decrease your interest payments.
  
• Are you in a cash crunch and regularly find it difficult to pay off your balance in full? Ditch rewards cards and stick with a low interest credit card, many of which carry below average APRs of between 8.99% to 13.99% instead of 19.99%.
  
• Credit cards come with a lot of responsibility. If you’re worried about losing track of your spending, don’t trust yourself to stay on budget, and are scared about potentially digging yourself into debt, consider the alternative: prepaid cards. Prepaids cards don’t help build your credit score like credit cards do, but they can’t hurt it either. And with a prepaid card, you’re using your own cash so you can avoid falling into debt. Plus, with Mogo’s prepaid card, you can also earn rewards like cash back and even bitcoin.
  
  

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1 - https://www.theglobeandmail.com/globe-investor/personal-finance/household-finances/many-canadians-in-the-dark-on-minimum-debt-payments/article34108191/