Credit Card Interest Fees

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.

Credit card interest rates vary by transaction types

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.

How does credit card interest work?

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:

Case study: Daily balance method vs. average daily balance method

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):

15.00% interest rate ÷ 365 days in year = 0.00041%

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:

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:

$5,000 + $6,000 + $7,000 + ($8,000 x 5) = $58,000

Next, we divide $58,000 by the number of days in the month to find the average daily balance:

$58,000 total balance ÷ 31 days in month = $1,870.96 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:

$1,870.96 average daily balance x 0.00041% daily interest rate = $0.767 interest owed per day

Finally, we multiply $0.767 by the number of days in December:

31 days in month x $0.767 interest owed per day = $23.77 total interest

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.

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.

Keep your eyes on your spending and your statement

To successfully avoid credit card interest charges, you have to do two things:

1. Don’t swipe your card for more than you can afford to pay off at the end of each grace period, and
2. Check every line of your statement and the payment due date each month, to make sure everything is accurate and you make your payment on time. Even if you have the funds available to pay off the balance in full, it’s easy to let a payment lapse because you weren’t paying attention to the payment due date. Unfortunately, depending on what your balance was, the interest charges caused by a mistake like that could take a serious bite out of your next month’s budget.