How APR & Average Daily Balance Work to Determine Your Interest

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Are you unpleasantly surprised when you open your credit card statement each month and see how much money you owe in interest on your account? How does a credit card company determine that number anyway? A couple of factors come into play—the annual percentage rate (APR) and your average daily balance.

The annual percentage rate is the rate of interest that you’ll pay on any outstanding credit card balances over the course of the year. There are two types of APR; fixed and variable. Because of the provisions of the 2009 Credit Card Act Accountability, Responsibility and Disclosure ACT (the CARD ACT), which made it more difficult for banks to raise fixed interest rates on credit cards, very few banks offer fixed APRs today.

The interest rates on variable APRs are calculated on the basis of some index (such as the prime rate or the rate of interest on Treasury bills) plus the margin that the bank adds in for their profit. If you have a variable interest rate, the bank doesn’t have to give you any advance notice if it increases the interest rate because the index it uses (like the prime rate) goes up.  But if the index rate goes down, you won’t necessarily see a decrease in your credit card interest rate; the bank may also set a minimum APR that it will charge.

Banks divide the APR by 12 to calculate your monthly periodic rate. Your daily periodic rate is calculated by dividing the APR by 365. 

Average daily balance

Banks use your average daily balance to figure out how much money they’ll be charging you interest on.

The average daily balance is the sum what you owe on your account each day divided by the number of days in the billing cycle. The example below shows a 10-day billing cycle, but real credit card cycles are longer.

Credit card charges: Your balance each day is:
Day 1 - $100 charge Day 1 - $100
Day 2 - no charge Day 2 - $100 ($100 + $0)
Day 3 - $50 charge Day 3 - $150 ($100 + $50)
Day 4 - $100 charge Day 4 - $250 ($150 + 100)
Day 5 - $50 charge Day 5 - $300 ($250 + $50)
Day 6 - no charge Day 6 - $300 ($300 + $0)
Day 7 - no charge Day 7 - $300 ($300 + $0)
Day 8 - $50 charge Day 8 - $350 ($300 + $50)
Day 9 - no charge Day 9 - $350 ($350 + $0)
Day 10 - no charge Day 10 - $350 ($350 = $0)
  Total: $2550

Divide that total by the 10 days in the billing cycle, and your average daily balance is $250.

Calculating your interest

Banks may use either the monthly periodic rate or the daily periodic rate to calculate the interest you’ll pay each cycle.

Suppose you have a $5000 average daily balance, your APR is 18% and there are 25 days in your billing cycle.

The monthly periodic rate would be 1.5% (18% divided by 12 months). Multiply that by $5,000 and your interest would be $75 for that month.

If the bank uses the daily periodic rate, your daily rate periodic rate would be .0005%  (18 % divided by 365 months). Multiply that by $5,000—and by 25, for the number of days in your billing cycle—and the interest you’ll pay again comes out to $62.50.  (If your billing cycle is 30 days, however, you’d pay $75 in interest.)

There’s one more wrinkle in figuring out how much interest you will be paying. Banks are allowed to charge different APRs for different types of credit card use. The lowest APRs usually apply to regular credit card purchases, and significantly higher APRs are applied for cash advance transactions. If you took advantage of a special balance transfer APR, you’ll pay that APR for the introductory period (but usually only on the balance you transferred). If you get more than 60 days behind in making a minimum payment on your credit card, you may be charged a penalty APR (the highest rate of all).

So banks will calculate each “pot” of money you owe separately, depending on what interest rate applies.

Although it’s good to understand how your interest is calculated, to reduce the amount you owe your best bet is to either pay off your bill each month (so you’ll owe no interest at all) or to make more than the minimum payments on your account (as much as you can afford). If you know that you’re going to have to carry a balance, try to choose cards with the lowest APR and with low or no annual fees.

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