Credit card interest rates are painful. As unsecured debt, cardholders are charged higher interest rates than they pay for home or car loans. And since many tend to use their credit card for everyday purchases, they can wind up paying interest on all of their purchases, which starts accruing on the day of the purchase. At the same time, other cardholders continue to use their cards frequently while avoiding interest charges altogether.
Credit Card Interest Made Simple
The key to reducing, or eliminating, your credit card interest charges is to understand how it is calculated. Credit cards calculate interest charges based on your average daily balance. At the end of every billing period, the cardholder's total unpaid balances at the end of each day are added up and then divided by the number of days in the statement cycle. So if you charge $1,000 on the first day of a 30-day billing period, then your average daily balance is $1,000, but if the charge is made on the last day of your billing cycle, your average daily balance is only one thirtieth of that, or $33.33.
Next, look at the interest rate, which is normally reported as an Annual Percentage Rate, or APR. To convert the annual rate to a daily, or periodic rate, divide it by the number of days in the year, 365. This will result in a very small number. For example, if your credit card as an APR of 15%, the periodic interest rate will be 0.000411%. Finally, you multiply the periodic interest rate by both the average daily balance and the number of days in the statement cycle, and that is the interest owed. So in the example of a $1,000 average daily balance at 15% interest during a 30-day statement, the total interest charge for the month would be $12.30.
That doesn't sound so bad, but don't forget how interest compounds. Some cards add interest charges to your daily balance once a month, while others add the interest every day that was accrued from the day before. When compounding daily, the effective interest rate of 15% APR is about 16.15%. This will raise the interest charges in our example to $13.27
Now for the Good News
Even though credit cards calculate interest on every charge, every day, nearly all will waive the charges when cardholders pay their entire statement balance in full and on time, before the statement due date. This period between the end of the statement cycle and the due date is known as the grace period, and it is your golden opportunity to avoid interest charges. In effect, the bank ends up loaning you money for free!
Nevertheless, when cardholders fail to pay off their entire balance, even by $1, or, worse, fail to make their payment on time, even by a single day, then they lose their grace period. Not only will cardholders owe interest on all their charges in their last statement cycle, but they will also begin paying interest on all the charges on the next statement cycle as well.
The grace period is lost until cardholders pay off their entire statement balance once again. Until that happens, every gallon of gas or loaf of bread purchased is accruing interest charges each day. Simply put, the way to always avoid credit card interest is to pay each month's statement balance in full and on time.
How to Minimize Interest Charges
Unfortunately, most American credit card users do not pay off their entire balance in full each month, a process known as carrying a balance. While some may not have enough money available to pay the entire balance, others may hold the shortsighted belief that it is easier to pay a smaller amount each month and incur interest charges than to pay off the entire amount.
Thankfully, once you understand how credit card interest is calculated, there are some strategies to minimize your interest charges when you have to carry a balance. The key is to reduce your average daily balance as much as possible. For example, cardholders need not wait until their statement's due date to make a payment. That date is merely the last date customers can make a payment to avoid late fees.
Instead, cardholders should make a payment as soon as they have the money available. Furthermore, there is no reason that cardholders can't make multiple payments throughout the month. For example, a cardholder who is carrying a balance can reduce his or her interest charges substantially by making payments each week, perhaps on receipt of a paycheck.
Finally, those who pay their credit card issuer electronically will have their payment credited several days earlier than they would if they mailed it. This will further reduce the cardholder's average daily balance while being less expensive and more reliable than sending a check through the mail.
Credit card interest is a real problem for many cardholders. It is so expensive that credit card users need to take a few minutes to understand how it works. And once they do, they can take steps to pay as little as possible.
This article originally appeared on www.comparecards.com/blog: "How Credit Card Interest Is Calculated & How To Pay Less."