Understanding Credit Card Interest

Nobody likes to pay interest on their credit card purchases. But if you know how your credit card works, you’ll learn when you do and do not pay interest and how much you can expect to pay. And once you know that, you can better plan to pay off your balance in full.

When interest is paid

You might assume that you’ll have to pay interest on every transaction you make, but you’d be wrong. In reality credit card companies grant their customers a 21 day interest free grace period. If you pay back the money you borrowed within 21 days you won’t be charged interest. But after that you’ll be charged interest daily, dating back to the day of the transaction.

You’ll also pay interest on cash advances (withdrawing cash from your credit card balance) and balance transfers (moving debt from one credit card to another.) These types of transactions do not come with a grace period and also have higher interest rates than typical purchase transactions.

To find out what your interest rates are, please refer to your credit card statement, your credit card agreement, or contact your credit card provider. A customer service phone number is most likely listed on the back of your credit card. If you do not receive a paper copy of your statement in the mail each month you are most likely receiving electronic statements. These are often emailed to you or made available in web banking. It’s a wise choice to review your statement each month, not only to make sure you don’t have any fraudulent charges (this happens far more often than you’d think) but also because the statement will inform you of any upcoming interest rate hikes.

How much interest is paid

The amount of interest you accumulate in each pay period is calculated in 4 steps. For our example, lets say your pay period begins on the 1st of each month and that you have an interest rate of 19.99%. In our example you will have started with a balance of zero, made a $500 purchase on the 1st, a $100 purchase on the 3rd, and no further transactions for the remainder of the month. Take a guess at how much interest you’ll be charged at the end of the month and then read below to see how close you are.

1. Calculating the average daily balance. This is done by adding up each daily balance of the billing period and dividing it by the number of days in that billing period.
   • (day 1 balance + day 2 balance + day 3 balance etc.) ÷ number of days in the billing period = average daily balance
   • Ex. (500 + 500 + 600 etc.) ÷ 31 = $593.55
   • Ex. OR ((500 × 2) + (600 × 29)) ÷ 31 = $593.55
2. Calculating the average daily interest rate. The company finds this rate by dividing the card’s APR by the number of days in the year.
   • APR ÷ 365 = average daily interest rate
   • Ex. 19.99% ÷ 365 = 0.0547%
3. Calculating the periodic interest rate. This is done by multiplying the average daily interest rate by the number of days in the billing period.
   • average daily interest rate × days in billing period = periodic interest rate
   • Ex. 0.0547% × 31 = 1.6957%
4. Calculating the monthly interest payment. This amount is determined by multiplying the average daily balance by the periodic interest rate.
   1. average daily balance × periodic interest rate = monthly interest payment
   2. Ex. $593.55 × 1.6957% = $10.06

Based on these calculations you will owe $10.06 in interest for your billing period in March. Was your guess pretty accurate?

Average credit card debt

According to the credit agency TransUnion, the average Canadian has credit card debt amounting to $4,154. Many credit card holders make sure to clear their balance each month. But many others rely on making minimum payments. The minimum payment is 3% of your balance. If you don’t make this payment each month you can expect the credit card company to start dishing out consequences. The first of which will most likely be a huge spike in your interest rate. If you were paying 15% to begin with you may see your rate jump to 24.99% (or even higher, depending on the company.) Getting a lower rate after that won’t be easy and often takes a minimum of 6 months. If you continue to miss minimum payments the company may freeze your account or shut it down altogether and send it to collections.

Minimum payments can be a big financial help when you are down on your luck, but only if it is temporary. According to this government of Canada debt calculator, if the average Canadian we mentioned above was to make only minimum payments until the balance of the debt was paid off, they’d be making payments for 19 years and 9 months! I don’t think anybody would disagree with the fact that that is just way too long! The thought of Andy Dufresne digging his way out of Shawshank comes to mind. Not only that, but on top of the original balance, they would have paid $4,927.59 in interest. That’s even more than the original balance! On your statement there may also be a minimum payment timeline. This is how long it will take you to pay off the balance using only minimum payments. It can take months, years, or even decades. Take a look your statement to find out how long your sentence is.

Take the right step forward

It’s plain to see that the best way to use a credit card is to pay for your purchases within 21 days of the transaction date. After that use minimum payments as a last resort. And never forget a payment! If you do anticipate being in debt longer than a few months, your best bet is to transfer your credit card balance to a line of credit, which will have a much lower interest rate. For information on how to do this and more, contact us today.