How Credit Card Interest Works

I was talking to a friend of mine the other day about credit cards. Him and I are both deadbeats. We make a lifelong habit of paying our bills on time and in full every month. In that way, we always avoid paying interest. Nevertheless, he did not seem to understand exactly how credit cards calculate interest. In his defense, it is not a simple subject.  While it is hard to explain, allow me to give it a shot.

How Credit Card Companies Calculate Interest

If you read the terms and conditions of any credit card, it will tell you that interest is calculated on the basis of your average daily balance.  In this way, it is much like the interest you earn in a savings account.  With your savings account, the earlier you make a deposit, the more interest you will have earned when you receive your balance. Likewise, with a credit card, the earlier you make a charge, the more interest you will owe by the time you get your statement.

What makes credit cards so unusual is that they have the possibility of a grace period. If you did not carry a balance at the end of your last statement, and you pay your balance in full by the due date following your current statement, all of the interest you would have owed is now forgiven. Congratulations, you are now the recipient of an interest free loan!

If you fail to pay off your entire balance, or you pay it late, you are still on the hook for all the interest accrued for each purchase. With the average daily balance computation, each purchase is essentially accruing interest from the moment of the transaction until the your payment is credited. Once your payment is credited, your balance falls by that amount for that day going forward. Don’t forget, that had you been continuing to make purchases after your statement closed, those purchases will also be accruing interest that will appear on your next statement. By failing to pay your balance in full and on time, you not only have to pay interest on all of the charges on your statement, but on all subsequent charges until such time that you pay off your entire balance. In this way, failing to pay off your balance on just one month, by just one dollar, will result in interest being owed on all charges during the 50 or so days(depending on the length of the month) from the first day of your last billing cycle up until your payment is received.  Being short one dollar, or late one day, can easily result in hundreds of dollars of interest being owed that would not have been otherwise.

The Two Ways Of Looking At Credit Card Interest

There are two ways of looking at the seemingly bizarre fact that being short a dollar can cost you hundreds. The way the banks explain it, you are always earning interest on all of your purchases. That interest can be forgiven if you pay your balance in full during the time called the grace period. There is a certain logic to the fact that there is no free lunch, you are always incurring interest.

On the other hand, there is a free lunch if you pay your entire balance on time. I always thought it was outrageous that a bank could legally charge hundreds of dollars of interest just for being a penny short of your balance when you make your payment.

Two Other Ways Of Calculating Interest

Until the CARD Act of 2009, credit card interest was always calculated using an obscure formula known as double cycle billing.  This strange method was only used for credit cards.  What they did was average out your balance over the last two billing cycles and charge you interest on that alone. If you had been carrying a balance, but had paid it in full, it would take two billing cycles until you no longer owed any interest. In this way, you were essentially paying interest on part of a balance you had already paid. While this method was outlawed for personal cards by the CARD Act, it is still permissible in the instance of business cards, so beware.

The other exception is for members of Chase’s Blueprint program. With this program, you can designate certain charges as “Full Pay” and others as “Split Pay”.  In this way, you can pay some charges in full with no interest while carrying a balance in the traditional way on other charges.

Conclusions

No matter if you carry a balance or pay every statement in full, it helps to know exactly how credit card interest is calculated.  Knowing the consequences can influence your decision whether or not to pay your balance on time and in full.