A Look At How Interest on Credit Cards is Calculated

Credit cards differ in the way they calculate interest, but the Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act) does pose some universal restrictions  on credit card interest calculations within the jurisdiction of the United States. One of the more clear benefits of the credit card law is a postponement of changes to interest rates on new and existing accounts. Some factors that may influence how your credit card interest is calculated are described hereafter.

Image source: Petr Kratochvil

Interest on credit cards is determined using periodic calculation of interest on existing account balances. If interest were not calculated periodically, one would essentially have more time to pay off one's credit card debt without interest being calculated on the balance. The method of interest calculation used by credit card companies is disclosed in the information within the credit card agreement. However, a credit card may promote a low interest rate in its advertising, but that interest rate may not necessarily be fully representative of the credit card agreement which itself may include additional interest rate calculations and variables not made evident in the credit card's advertising.

Looking at how interest rate on credit cards is calculated in more detail can be more useful than simply knowing what the Annual Percentage Rate (APR) is because the APR does not include important aspects of interest calculation such as the inclusion of fees and method of calculating balance as part of the interest rate function i.e. interest on a credit card is typically more dynamic than the application of an APR to a monthly balance because of variability in balance due, credit card terms, and interest rates.

• Fees included in interest rate calculation

Finance charges are often dollar values or percentage rates. In the case of percentage rates, finance charges are added to the total amount of credit card interest charged. For example, if Mr. X incurred a finance charge for paying late or using a fee only credit card service, that charge may either be an added fee such as $5.00 or an added interest rate such as .01%. The more finance charges apply and are allowable under the credit card terms, the greater the potential interest charged.

The difference between a dollar or interest rate charge can be of significance in regard to finance charges. For example, if Mr. X has an unpaid credit card balance of $450.00, $15 of which is unpaid fee carried over from the previous month, interest will be calculated with that fee included.

• Interest on outstanding balances

It is usually clear that interest is charged on a credit card's outstanding balances outside of that credit card's grace period. However, how this balance is determined is also variable. In other words, how the balance is calculated, and there are more than one ways of doing this, can affect how much interest is charged.

For example, Mr. X's credit card agreement uses the average daily balance method to determine what the balance is, and what time period within the billing cycle the balance is taken from. Another method deducts payments made and charges interest on the average daily balance thereafter. Consequently if payment is not included in the balance calculation, until the next billing cycle, more interest will be charged.

• Frequency of calculation

A credit card company may calculate interest daily, weekly or monthly depending on the terms of agreement; these rates are called periodic rates. Periodic rates are determined by dividing the APR by the amount of periods for which interest is charged. For example, if a daily periodic rate is used, the APR is divided by 365 and then the resulting number is the rate charged to any unpaid balance past the billing cycle. If calculated daily, the total interest accumulated by the end of the payment period will be higher than monthly periodic interest calculations.

• Base and added interest

Credit card interest rates themselves may be divided in to two numbers, so it can be important to read the fine print on a credit card agreement because it may tell you if the quoted APR is all inclusive or if it excludes the base rate. A base rate may be a national bank rate such as the prime rate which is an interest rate determined by the Federal Reserve Bank and fluctuates with increases and decreases with the Federal Funds Rate.

• Variable Vs Fixed rate interest

If a credit card has a variable rate, the interest calculated on the balance may differ between billing cycles. A variable rate may be used to changes in the banks cost management, base interest rates, market conditions and bank policy. Fixed rate credit cards do not experience fluctuations in interest rates so long as the contract between the bank and card holder allow such.

Source: http://www.ftc.gov (U.S. Federal Trade Commission)