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Every time I pay my credit card part of me wants to hold something back.

Like many people, my wife and I use our credit card for most daily purchases. (I even have a student lender which accepts credit card payments without a fee.) We have one solid rewards card with a respectable limit, and as long as we stay on top of our payments the benefits far outweigh any costs.

It's just… costs of living look so much higher when you pay them all in one lump sum. In a sense it's a nice reminder of how all those little expenses add up. In a far more urgent sense, it's not easy to send off thousands of dollars to Capital One (COF - Get Report) every month. I'm always tempted to keep some money back. It's not that I don't want to pay off the credit card bill. There's just something comfortable about having that money in my checking account.

That sense of well-being would come at one heck of a cost though.

What Is Credit Card Interest?

Interest is the rate your credit card company charges for carrying a monthly balance on your card. Note that this article applies to any mainstream card on the market at time of writing. It's possible that niche products might obey different rules.

Critically, it's important to understand that credit cards don't actually charge interest just for making purchases on the card generally. While some will charge a monthly fee or other associated costs (see our article on finance charges for more information on that subject) those aren't interest. Nor do companies charge interest for making purchases or carrying a balance to the end of the month.

Instead, at the end of each billing cycle, after you've made your minimum payments, if you still have an unpaid balance the company charges interest on that amount. It's what they charge for lending you money past the end of the month.

How Is Credit Card Interest Calculated?

What credit card interest is, that's relatively straightforward. Avoiding it is also pretty simple (in theory, if certainly not in practice). How your credit card company calculates interest… well, that's more complicated. So here's the breakdown:

First, if you begin any billing cycle with a $0 balance on your credit card you enter what's called the "grace period." During the grace period the credit card company charges no interest on your purchases as you go. As long as you pay the entire balance at the end of each billing period, you maintain the grace period. If you pay the entire balance at the end of any given billing cycle, you re-enter the grace period.

While standard purchases with your credit card will fall under the grace period, it doesn't always apply. Most significantly, most credit cards immediately begin charging interest on a cash advance immediately regardless of the grace period.

• Note - We keep using the term "billing cycle." Your credit card bill is calculated on a monthly basis, but when exactly that begins and ends might vary. The billing cycle is a one-month period during which all charges apply to a specific bill. It might run from the 15th of one month to the 14th of the next, for example, or from the first day of each month until the last.

Now, let's say you end a billing cycle with a balance still on your card. This will happen whenever you pay less than the full amount due. It's critical to understand that this applies EVEN IF you make your minimum monthly payment. Interest applies whenever you have a remaining balance due, even if you keep on top of your required payments.

When this happens you exit the grace period. Now the credit card company will do two things:

  • It will charge interest on the entire remaining balance due after you make your payment.
  • It will also begin charging interest on all new purchases going forward.

This means that the credit card company will not charge interest on any amount that you paid from the last month's bill. However, it will charge interest on every charge that shows up on the coming month's bill. You won't have an opportunity to pay any of that off pre-interest.

Let's look at an example. Say you enter January with no balance on your credit card and make $2,000 in purchases. At the end of the month you get a bill for $2,000 with no interest and you pay $1,000 of it.

Now you will enter February with a balance on your card of $1,000, meaning you have exited the grace period. Over the course of the month you make another $2,000 in purchases. At the end of February your credit card bill will include interest for January's unpaid balance ($1,000) and for all purchases in February ($2,000). If you pay less than the full amount, the next month's statement will include interest for that unpaid balance as well as for that month's purchases.

Average Daily Basis vs. Daily Balance

There are two main methods for calculating the interest on your statement each month.

The most common is called the Average Daily Basis (ADB) method. To calculate interest under on an average daily basis, the credit card company does the following:

  • It takes your APR (the annual percentage rate) and divides by 365. This gives your ADR, average daily rate of interest.
  • The company then multiplies your ADR by the number of days in a given billing cycle. For example, in a 30-day month, the company will multiply it by 30. This gives your average monthly rate of interest (AMR).
  • Finally, the company then applies that average monthly rate to your statement at the end of the month.

For example, say you have a $2,000 balance at the end of a 30-day month and a 17% interest rate. An ADB method would do the following:

  • ADR = 17/365 = 0.0465%
  • AMR = 1.39%
  • Interest = $2,000 x 1.39% = $27

The alternative, less common, method for calculating interest is called the Daily Balance method. Using the daily balance method, a company will calculate your average daily rate the same way that it does using the average daily basis method.

Then the company applies your average daily rate to the closing balance on your credit card statement every day. It then adds those daily interest amounts together at the end of the month to get the full month's interest.

So, for example, take our example above. You have a 17% interest rate on your credit card, which gives an average daily rate of 0.0465%. A daily basis calculation would look like this:

  • Day 1 Balance: $0 x 0.000465 = $0 interest (Remember that our ADR is 0.0465%. When calculating a percentage as a decimal we move the decimal two places over.)
  • You make $150 in purchases the next day.
  • Day 2 Balance: $150 x 0.000465 = $0.069
  • You make $100 in purchases the next day.
  • Day 3 Balance: $250 x 0.000465 = $0.116

Each day's balance is calculated in this way. At the end of the month, the credit card company adds up these balances to get the full month's interest.

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