Most of us know the basics of how credit cards work: use your credit card to earn rewards, pay off your balance in full and on time, and avoid interest charges. Simple enough, right?
While there’s no denying that logic or that paying with plastic can offer a slew of benefits (you only need to look at the best credit cards in Canada for proof), things do get considerably more complicated when balances are carried over and interest charges enter the equation. This is especially true when you dive into the specifics of exactly how credit card interest works.
With that in mind, we’ve shed some light on how credit card interest is calculated to help you better manage card debt or avoid it altogether.
Credit card interest – some of the basics
First and foremost, it can’t be stressed enough that if you pay off your balance in full each and every month by the due date on your credit card statement, you will not be charged interest on your purchases. So, if you have a travel credit card or cash back card, that means you can pocket rewards on your everyday spending interest free.
Interest on credit card purchases only comes into effect when you carry a balance from one month to the next. It helps to think of a credit card as a short-term loan – if you don’t pay back what you owe on time, you’ll have to pay extra.
Second, interest charges are not to be confused with annual fees. Interest is the cost of borrowing money while an annual fee is a fixed charge found on some premium credit cards and has no connection to your balance or spending.
Lastly, there are three different types of transactions that you can make on a credit card:
- Purchases (what this blog post focuses on) is the most common type of transaction and refers to everyday purchases you make on a credit card
- Balance transfers, which refers to the transfer of debt from one credit card to another
- Cash advances, which refers to the withdrawal of cash from your credit card’s limit
Interest calculations for balance transfers and cash advances tend to differ slightly from purchases.
What is APR – and what does it have to do with credit card interest?
You’ve likely seen the term APR before on your credit card statement or cardholder’s agreement.
APR stands for annual percentage rate and is used by financial institutions to calculate the amount of interest cardholders owe on any balance they carry over. In other words, it’s the cost of borrowing money on a credit card.
While seeing the word “annual” may lead you to think that credit card interest is charged once a calendar year, that’s not the case. It’s simply standard practice to present interest in annual terms – similar to how kilometers per hour is the standard to measure speed – and the actual percentage someone pays in interest may be higher or lower than a card’s APR depending on how long they carry a balance.
For example, if your credit card has an APR on purchases of 19.99% but you carry a balance for four months after which you pay it off completely, your effective interest rate would be 6.66% [(19.99% ÷ 12) X 4].
Most rewards credit cards in Canada have an APR of 19.99% on purchases, which can climb to as high as 22.99% for non-traditional credit card transactions such as a cash advance. On the other hand, low interest credit cards have APRs as low as 12.99% and 8.99%.
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What is a credit card grace period?
Usually 21 days, the grace period refers to the window of time from when you first receive your monthly statement to when your balance is due during which you won’t be charged any interest on your purchases.
If you completely pay off your credit card balance during this grace period and by your statement due date, you won’t be charged any interest.
Note: while everyday purchases made on your credit card are granted a grace period, balance transfers and cash advances are not.
The consequences of not paying your bill in full by the grace period
If you don’t pay your balance in full by the grace period, you’ll be charged interest for each day from when you originally made your purchases – not just from when you received your statement – and will continue to be charged interest each day until you pay off what you owe in full.
For example, let’s say you bought a television on March 3rd and received your statement on March 30th. If you don’t pay off your balance in full by the end of the grace period on April 20th, you’ll be charged interest retroactively each day starting from March 3rd (when you first made the purchase) up until April 20th. You’ll then be on the hook for interest moving forward until you completely pay back what you owe.
Usually, carrying a balance also means you’ll accumulate interest on new purchases immediately.
This makes it all the more important to monitor your spending and only use your credit card for purchases you can afford to pay for at the end of the month.
When are you charged interest on a credit card?
In almost all cases, financial institutions calculate your interest on your daily balance but charge you monthly.
Missing payments can increase your APR
Aside from the obvious fact that missing a payment will lead you to carry a balance, it can also mean being hit with a higher APR, and therefore, higher interest fees.
Many cardholder agreements even have explicit terms that state if you miss two payments in a row, your interest charges will be calculated using a higher APR.
While you can often negotiate these terms with your bank (and it’s recommended you do), it’s not guaranteed that they will lower your APR. So, always be sure to keep a close eye on due dates and if you can’t pay off the entire balance at once, at least pay what you can on time.
Do I owe interest if I make the minimum payment?
If you only make the minimum payment, you’ll still pay interest. In fact, making just the minimum payment is arguably the least effective way of tackling credit card debt second only to making no payments at all.
Since a minimum payment is typically 3% of your previous balance, most if not all of your minimum payment will go towards paying interest while very little will go towards the actual balance you owe.
If you look closely at your credit card statement, you’ll even find an estimate of how long it would take you to pay your balance in full if only minimum payments are made. As shocking as it may seem, it’ll often be several years if not decades.
If you do carry credit card debt, always aim to make more than the minimum payment and consider setting payments up regularly – even before you receive your monthly statement. Paying just twice the minimum payment could help you save years of paying interest.
How credit card interest works – in 4 steps
To illustrate how credit card interest works, we’ll be using the following simplified example:
- Let’s say you have a credit card with an Annual Percentage Rate (APR) of 19.99% and a 30-day billing period
- On day 1 : You carry over $1,000 in money owed and interest from your previous statement
- On day 3: You make a new purchase of $500
- Assuming no additional payments or charges are made on your credit card, how much interest would you owe at the end of this billing period?
Step 1: Calculate the average daily interest rate
First, we’ll have to find the daily interest rate – in other words, the amount in interest someone owes every day they carry a balance.
This is done by dividing the card’s annual percentage rate (APR) by the number of days in the year.
Daily interest rate = APR ÷ Number of days in the year
In this example:
Daily interest rate = 19.99% ÷ 365 = 0.0548%
Step 2: Calculate the periodic interest rate
Next, we’ll have to multiply the average daily rate (calculated above) by the number of days in the statement period (almost always 30 days) to find the periodic interest rate.
Periodic interest rate = Daily interest rate × Number of days in a billing period
In this example:
Periodic interest rate = 0.0548% × 30 = 1.643%
Step 3: Calculate the average daily balance
Since people’s credit card balances tend to fluctuate day-to-day, credit card companies calculate how much interest someone owes based on their average daily balance carried over the length of each monthly statement period.
To calculate the average daily balance, you’ll need to add up your balance for each day and divide that by the number of days in the billing period (almost always 30 days).
Average daily balance = (Day 1 Balance + Day 2 Balance + Day 3 Balance + Day 4 Balance etc.) ÷ Number of days in the billing cycle
In this example:
Average daily balance = ($1,000 + $1,000 + $1,500 + $1,500 etc.) ÷ 30 = $1,466.67
Step 4: Calculate the monthly interest payment
This is the most straightforward part of the calculation and involves multiplying the periodic interest rate from Step 2 by the average daily balance from Step 3.
Average monthly interest payment = Periodic Interest × Rate Average Daily Balance
In this example:
Average monthly interest payment = 1.643% × $1,466.66 = $24.10
Based on our calculations, you would owe $24.10 in interest just in this month’s billing period. Your interest payments can quickly add up from one month to the next as you make more purchases on your credit card or take longer to pay off your balance.
In most cases, banks also compound interest (something we didn’t factor in our simplified calculation above). What that means is that your interest from one day will be added to your balance for the next day – further increasing your interest payments bit by bit over the long term.
If compound interest was factored into your example, the calculation would abide by the following logic:
Day 1 Balance: $1,000 x 0.0548% (APR/365) = $0.55.
This daily interest would then be added to create a new balance of $1,000.55.
Day 2 Balance: $1,000.55 x 0.0548% = $0.55.
This interest would then be added to create a new balance of $1,001.10, and so on for each day in the billing period.
Lastly, we wanted to highlight how our examples above are only for illustrative purposes to provide a high-level look at how credit card interest works. Credit card interest calculations can vary by card. Even when reaching out to the big banks’ customer service representatives, there was a lot of nuance in terms of when and how interest is calculated in real terms.
How to save on credit card interest
Track your spending
Whether or not you currently carry a balance, keeping track of your credit card spending is crucial.
By knowing how much you’re spending, you can dial back your purchases before your balance becomes unmanageable and avoid the shock of seeing a larger-than-expected bill when your credit card statement arrives. The rule of thumb with credit cards is: only spend what you know you can pay for at the end of the month.
If you are carrying a balance, you’ll also want to limit your card spending and opt for cash instead until you clear off your balance.
Schedule regular payments to your credit card
You don’t need to wait for your statement to arrive in the mail before paying down what you owe. Instead, make multiple payments per month to chip away at your balance faster.
Arguably the simplest way to do this is by setting up automated payments from your chequing account to your credit card. That way, you won’t forget to make payments and you’ll guarantee that some of your money is being put towards your credit card debt before you spend it on something else.
Don’t go overboard here though, because if you’re not careful you may end up withdrawing more money than you have and get hit with overdraft fees. So, ensure your payments are consistent but manageable.
Using a balance transfer credit card
If you currently have a large balance on your credit card, you’re likely paying an interest rate of upwards of 19.99%. What if you could pay 0.99% or 3.99% instead? By using a balance transfer credit card, that’s a possibility.
A balance transfer that moves your balance from a credit card with a high APR to a card with a super-low APR can go a long way in helping you save on interest and paying off your debt faster. The BMO Preferred Rate for example currently has an offer that charges 3.99% on balance transfers for the first nine months (with a 1% fee).
It’s important to keep in mind that super-low rates on balance transfer credit cards are usually only available for a limited time (typically six or ten months) before their rates go back up. The good news in the case of many of these cards (such as the BMO Preferred Rate Mastercard) is that even when the limited time APR ends, the fixed APR will often still be lower than what most rewards credit cards charge. You’ll want to read the terms of a card’s policy to be sure, however.
Use a low-interest credit card
While it’s easy to see the allure of rewards credit cards, these cards tend to have high APRs that can lead you to pay more in interest than you would earn in points or cash back if you consistently carry a balance.
So, if you’re on a tight budget or suspect you’ll carry a balance for several months in a year, a low-interest card could be a better fit and potentially help you save hundreds of dollars. Some of the best low-interest credit cards in Canada have APRs on purchases as low as 8.99% – which is half the usual 19.99%.
Even just having a low-interest card as a backup can be a good strategy to save on interest in case you need to make an emergency purchase and don’t have the wherewithal to pay it off on time.
Ask your bank for a lower APR
If you’ve been a long-time client or your account has generally been in good standing, your bank may be open to negotiating your card’s terms and lowering your APR. As the saying goes “it doesn’t hurt to ask,” so consider reaching out to your bank’s customer service team over the phone or a financial advisor in person if you’ve recently racked up some card debt.