Credit Cards: How Do Interest Rates Work?

If you’re new to credit cards, you probably won’t understand how interest rates work. Honestly, most people with credit cards don’t get exactly how they work.  I’ll start with an example, and then explain.

In January, you make a charge of $100. Your credit card has an APR of 15%. Every month, a finance charge of that 15% APR is added to your balance.

Month Interest (15% APR) Total
January $100
February $1.24 $101.24
March $1.12 $102.36
April $1.24 $103.60
May $1.20 $104.80

*This is an unrealistic simple example. This does not includes any payments you make or other fees added to your account.

Annual Percentage Rate (APR)

If you’re looking at the table above, you might get confused and can’t see how 15% of $100 equals $1.24(February). That’s because APR isn’t a straight-forward percentage rate.

The Annual part of “Annual Percentage Rate” doesn’t mean it’s calculated annually. It’s actually calculated once a month for each day but based on the percentage for the year. I know, confusing, but stick with me…

January Interest… One Day At A Time

Your Annual Interest Rate is 15%. But since your interest is calculated daily, you want to know what your daily interest rate is. This is called the daily periodic rate, but that’s not something you need to remember.

15%(APR) ÷ 365(days) = 0.041% daily rate

Now you know that with a 15% APR, you are charged 0.041% every day. In our example of a $100 balance, multiply that to get a daily interest amount.

$100(balance) x 0.041%(daily interest) = $0.04 (interest per day)

$0.04 per day. Simple enough… but remember that’s for one day and not the whole month. Since it’s calculated for the whole month at a time, multiply that by the number of days to get the monthly interest.

$0.04(daily interest) x 31(days) = $1.24 (interest for the month)

There you have it. For just one month, January, your interest is about $1.24. In February your interest is added to your account and becomes a part of your new balance. To get your February interest, do the whole thing over, but instead of a $100 balance, you’re starting with $101.24 ($100 plus the $1.24 interest). It’s actually more complicated than that since you may have made a payment, lowering your balance, or you may have been charged some kind of fee.

Also keep in mind that not all banks calculate the same, for example, they may figure out the daily periodic rate by dividing your APR by 360, rather than 365.

Ernesto Jaboneta

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