Almost everyone we ask is unsure about calculating credit card interest, and credit card issuers make it quite challenging to find the relevant information. As a result, many young Canadians are paying an exuberant amount in credit card interest, and they do not even realize it.
Simply put, credit card interest is calculated daily based on Daily Periodic Rate (DPR) and credit card balance past the grace period. The tough part? Tracking and calculating the rate and the balance.
Let's take Tom's example: Tom got a credit card three months ago with a $2,000 credit limit and 24% interest rate. Tom bought a laptop 60 days ago for $1,000 and a sweater 25 days ago for $100. How much does Tom owe in interest today? To answer that, let's dive a little deeper into creditor lingo.
How credit card interest rates work
Annual Percentage Rate (APR)
APR is an equivalent annual interest rate we pay on our credit cards, loans, mortgages etc. If you were carrying a $100 balance and paid $1 in interest after a month, you paid 12% in APR:
$1 interest ÷ $100 balance x 12 months
In Tom's case, the 24% interest rate mentioned above should be his APR. You must search through the credit card terms and conditions with the explicit APR rate to avoid surprises. If you can't find it, give your credit card company a call to confirm it.
Daily Periodic Rate (DPR)
Although credit card issuers bill you monthly interest amount, they charge you interest daily based on the Daily Periodic Rate (DPR) defined as:
DPR = APR ÷ 360 days (it can be 365 days but use the 360 days if you are not sure)
Tom's DPR is 0.067% (24% interest / 360 days).
When interest is charged on a credit card
Most credit card companies give a certain number of days before charging interest; it's called the grace period. Once the grace period is over, interest is charged daily based on the DPR explained above for every purchase you make. Credit card issuers are not obligated to give a grace period. Usually, the period is 21 days, but you must make sure what the grace period each for all of your credit cards.
Let's assume Tom's credit card company gave him 30 days to pay off his balance without being charged interest. He is within his grace period for the sweater he bought but not his laptop purchase. Tom will be charged 0.067% interest daily on the laptop he bought until he repays it in full.
Total Daily Balance
It's an aggregate of the daily balance of your purchases that are past the grace period. Here's how to calculate it:
day 1 balance of purchases past the grace period + day 2 balance of purchases that are past the grace period + day 3 balance of purchases that are past the grace period...
As you can see, calculating the daily balance can be quite complicated and time-consuming. Wouldn't it be nice if credit card companies gave us access to a detailed breakdown of the daily balance and daily interest rate on our phone?
Tom's total daily balance that will be charged interest is $30,000 ($1,000 x 30 days).
Calculating the interest amount
Now that you have all the information you need, here's how you would calculate the interest amount for a specific number of days:
Interest amount = (APR ÷ 360 days) x total daily balance
Tom owes $20 in interest to his credit card company:
(24% ÷ 360 days) x $30,000 total daily balance
Pro tips on how to avoid credit card interest:
- Read the fine prints! Know the APR, the grace period and any hidden fees that the credit card might charge you.
- Pay off your credit card balance RELIGIOUSLY every single month within the grace period. Credit cards are a great way to earn points, but you should never borrow with your credit card.
- If your purchase will take more than a month to pay off, get a loan. If Tom took a loan with 8.9% interest to finance his laptop, he would have paid $10 in interest to borrow for 60 days instead of the $20 he paid to his credit card issuer.
- Avoid paying only the minimum amount suggested by your credit card issuer; it's designed to keep you in debt for a long time. Read more about it here.
Note: We have excluded the compounding effect from interest calculation for simplication.