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There are many different fees associated with credit cards, but interest is likely the biggest one you’ll ever pay. Simply put, if you use your card to make purchases, balance transfers and/or cash advances, you may be subject to some hefty interest charges – especially if you carry a balance. Here’s a rundown of the three different types of transactions you can make with your credit card and how their associated interest fees are calculated.
|Fee||What is it?||How much?|
|Interest on Purchases||The interest charged on unpaid balances, where credit cards have been used to pay for goods or services. Interest starts accumulating after the grace period runs out and dates back to the day you made your purchase.||Typically 19.99%, but it may be lower, depending on the type of card (i.e. a low-interest credit card may only charge 10-12%)|
|Interest on Balance Transfers||The interest charged on any balance transferred from one card to another. Interest is charged by the new card you transferred your balance to and starts accumulating right away.||Typically 21.99%, but you may find promotional offers as low as 0% for a specified period of time|
|Interest on Cash Advances||The interest charged when you use your credit card to take out cash. Interest starts accumulating the same day you make that transaction.||Typically 21.99-24.99%|
Aside from purchases, there are two other types of transactions you can make with your credit card: balance transfers (where one credit card is used to pay off another) and credit card cash advances (when you take some of your available credit limit out as cash). In both cases, interest starts to accrue immediately following the transaction. There is no grace period on balance transfers and cash advances.
Interest rates on credit cards are often much higher than other types of loans, such as personal lines of credit or mortgages. It is not uncommon to pay an annual interest rate of 19.99% on unpaid balances, and even more so for balance transfers and cash advances. If you can’t afford to repay your full balance at the end of each month, you should expect to see interest charges on your credit card statement – and they can add up fast.
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To answer the question "how does credit card interest work?" it's first important to recognize that credit card interest can be calculated in one of two ways: either via the daily balance method or the average daily balance method.
The daily balance method calculates interest on overdue balances at the end of each day. It is determined by calculating the daily interest rate (the annual rate divided by the number of days in the year), multiplying that by the balance on each day then adding the interest owed for every day in the month.
The average daily balance method calculates interest by adding up the total daily balances in a month, dividing that figure by the number of days in the month and then multiplying that by the daily interest rate.
Let’s take a look at an example of how interest fees are calculated using both methods:
John made major purchases in late December using his credit card. When he received his statement in early January, he had a balance of $8,000. His card carries a 15.00% annual interest rate and accrues interest using the daily balance method. Assuming he does not pay his balance off in full by the end of the grace period, how much interest will he owe for December?
To find out how much John will owe in interest using the daily balance method, we must first find the daily interest rate by dividing the annual interest rate by the number of days in a year (365):
Next, we multiply the daily interest rate (0.00041%) by the balance for each day. For example, on December 24th John owed $5,000, so we multiply $5,000 by 0.00041% which equals $2.05. We do this calculation for each of the days in which John had a balance. Then we add up all the daily interest charges to find the monthly total. Using the daily balance method, John would owe $23.78 in interest for the month of December.
Now let’s look at this same example but say John’s credit card uses the average daily balance method, instead. First, we have to add the balances for each day. We can exclude days with balances of zero, so December 24th is the first day ($5,000). To this, we add all the remaining days and their balances in the month:
Next, we divide $58,000 by the number of days in the month to find the average daily balance:
We then calculate the daily interest rate by dividing the annual rate (15.00%) by the number of days in the year (365), which we know from above equals 0.00041%. With that, we multiply the average daily balance by the daily interest rate to determine how much interest is owed per day:
Finally, we multiply $0.767 by the number of days in December:
The average daily balance method in this example results in $23.77 of interest, which is almost identical to the $23.78 found using the daily balance method.
|Date||Balance||Daily Balance Method||Average Daily Balance Method|
|Dec 1-23||$0.00||$0.00||24 x $0.767 = $18.40|
Note that in our chart we show interest charges for December 1 to December 23 (24 days) even though there wasn’t a balance for these days. We do this because in calculating the average daily balance for a month, we must include days where there was no balance.
To successfully avoid credit card interest charges, you have to do two things: