How Do Credit Card Companies Charge Interest on Your Balance?

If you routinely carry credit card balances, one of the biggest drains on your wallet comes in the form of interest charges. And as you work to pay down your balances, you have probably noticed that paying the minimum payment doesn’t really do much in reducing how much you owe. This is because a large portion of your minimum payment actually goes to the interest charges your balance accrues.

There are the three main ways that credit card companies figure your interest charges: average daily balance, adjusted balance and previous balance.

Average daily balance

This is, by far, the most common way that credit card companies figure your interest charges. Every day, your charges and payments are tallied. At the end of the month, an average is figured. For a typical 30-day billing cycle, here is simplified version of how it might work: You have $200 for your balance for the first 25 days. Then you charge $900 on the 26th day for a big ticket item. You balance would be figured this way. The first 25 days saw a balance of $200 each day, so you would take 25 x 200 = 5,000. For the last 5 days of the month, your average balance each day was $1,100 ($900 for the new charge plus the $200 you already had). So, 5 x 1,100 = 5,500. Add the two numbers together and divide by 30 to get the average daily balance for the whole month: 5,000 + 5,500 = 10,500. 10,500/30 = $350. The interest charges would be figured using that $350 as a base.

But daily balance interest charges have another side. Your interest charges, in some cases, may be figured daily depending on your balance and the daily rate of interest that you have. This is a little different from average daily balance, and more insidious. Consider: You have an annual rate of 13 percent on your credit card. Daily interest is 0.0003561 percent. Some credit cards will charge you interest at that rate each day. It may seem like a small amount, but being charged each day can add up, since the daily charges are added to your balance for the next day, and then interest is charged on the whole.

Adjusted balance

This almost never happens. Why? Because it gives you an advantage in terms of your credit card payments. The company uses, as a starting point for the month, your balance from the previous month. All charges are added from the month, and all payments are subtracted. So if you start with a $500 balance, and charge $300 to your card, but you have made a payment of $400, your adjusted balance is $400. Your yearly interest rate is divided by 12 and multiplied by the $400 to get your interest charges for the month.

Previous balance

This system is as simple as the adjusted balance to figure, but previous balance usually favors the credit card companies. Basically, the credit card company takes whatever your balance is at the end of the month and uses that to figure your monthly interest charges.

Paying attention to how your interest charges can help you make wiser decisions with your credit card purchases. Of course, the best way to deal with credit card purchases is to limit them to what you can pay off each month. That way you won’t be carrying a balance, and you won’t incur any interest charges.

Guest post from Miranda Marquit, who writes about personal finances for the All Business Personal Finance Corner and edits information on debt consolidation for DestroyDebt.com.

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