Credit card companies charge interest on a monthly basis, based the annual percentage rates (APR) listed in the disclosure statements that came with your credit card application. Keep in mind that interest rates may vary depending on the type of transaction conducted. They may also be raised if you are late with a credit card payment or miss one entirely.
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The good news is that, with the exception of imposing a penalty interest rate for late or missed payments, a credit card company cannot just arbitrarily raise your rate without informing first. According to the Federal Reserve a credit card company must give you a 45-day advance warning before raising your rates or making any other significant changes to the terms. Within that time, you have the option to close your credit card account or changing it so no further charges can be made.
How do credit card companies calculate my interests?
A very good explanation of how credit card interest is charged is provided by the Discovery Channel’s How Stuff Works program. They start by pointing out the three main methods of interest calculation. Those methods are:
- Adjusted balance
- Average daily balance
- Previous balance
Each credit card company uses at least one of these methods to determine your monthly interest charges. Some combine multiple methods together depending on the terms of a particular card and your circumstances. Regardless of the chosen method, interest is typically calculated at the end of your monthly billing cycle.
What is the adjusted balance method?
Using the adjusted balance to calculate credit card interest is the one that is probably most beneficial to the customer. That’s because this method allows for payments made toward the previous balance to be subtracted before interest for the next cycle is calculated.
In essence, the adjusted balance method results in the customer paying less interest when paying down the credit card. We’ll do our best to explain it as simply as we can here.
With the adjusted balance method, the calculation starts with the ending balance of your previous billing cycle. From there they add in any new charges made during the current billing cycle; these charges can include purchases, cash advances, and balance transfers. They then deduct your last payment from that total amount and use the resulting number as the basis for your interest calculation. They multiply that number by the monthly rate that applies to your card.
What are the average daily balance and previous balance methods?
The average daily balance method of calculating credit card interest is the one used most often by issuers in the United States. Where the adjusted balance method favors the customer, and the previous balance method favors the credit card company, the average daily balance favors both parties as equally as possible. This method works very simply: the credit card company keeps a running total of all your transactions over the course of the billing cycle and then charges interest based on the average amount of your balance on any given day.
The previous balance method of calculating credit card interest is by far the easiest to understand. With this method, the credit card company simply takes the ending balance amount from your previous billing cycle and multiplies it by your monthly interest rate. This benefits the credit card company because they’re charging interest on what you owed last month, despite the fact that you’ve made a payment since then.
Is there a way I can find out how much total interest to pay?
Thanks to the new rules for credit card companies that went into effect last year, even those who are not very good at math have an easy way to find out how much total interest they’ll pay on their credit card debt.
The new rules require credit card companies to include a disclosure on your monthly statement, which shows how much interest you are paying pay. If you make only the minimum monthly payment, they must tell you the amount of time it will take to pay off the balance. This disclosure typically is published in an easy-to-read chart.
You might be surprised when you read the information found in this disclosure. Hopefully it will be an encouragement to you to pay off your credit card debt early to avoid obscene interest charges. With average rates hovering anywhere between 12% and 19%, none of us really needs to carry balances in the thousands of dollars.
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