Credit Cards and You: Getting the Most from Your Credit Card

How Interest Charges Are Calculated

If you always pay the amount owing on your credit card by the payment due date, you never have to pay interest.

If you don't pay the amount owing on your credit card in full, by the due date, your credit card issuer will charge you interest depending on the type of transaction: a new purchase, a previous purchase, a cash advance or a balance transfer.

New purchases

• These are purchases that appear on your monthly statement for the first time.
• They can be interest-free under certain conditions.

Previous purchases

• These are purchases that were listed on a previous statement and not paid off.
• You're charged interest from the date you made these purchases until they're paid for in full. Some credit card issuers charge interest from the date the purchases are posted to your account.

Cash advances and balance transfers

• You're charged interest from the date you made the cash advance or balance transfer.
• You don't benefit from an interest-free period on these transactions.

When your credit card company calculates the interest you owe, it normally uses either the "average daily balance method" or the "daily balance method". Although the two methods differ in their way of calculating interest, they generally yield the same interest charge. To find out which method your credit issuer uses, check your credit card agreement or contact the issuer.

Here's how both methods work:

Average daily balance method

The average daily balance on your credit card is the balance you carried during the billing period, averaged by the number of days in the billing period (usually 30 or 31). Your average daily balance is calculated at month's end by adding the balance at the end of each day, then dividing the total by the number of days in the billing period. To calculate the interest charged for the month, you multiply the average daily balance by the daily interest rate (obtained by taking the annual interest rate and dividing by the number of days in the year [365]); then you multiply the result by the number of days in the billing period.

Daily balance method

Whereas the average daily balance method only makes a month-end calculation of the interest owed, this method calculates interest owed at the end of each day of the billing period. To calculate the daily interest charge, you multiply the daily balance by the daily interest rate (obtained by taking the annual interest rate and dividing by the number of days in the year [365]). Next, add up the resulting daily interest charges to obtain the amount of interest charged for the month.

Example: Methods of Calculating Interest

The following example shows how the two methods work.

Mrs. Smith received her new credit card on January 1. On January 5, she made a purchase of $3,000. Her January statement, which covers her transactions between January 1 and January 31 (a 31-day billing period), has a payment due date of February 19.

Let's assume that Mrs. Smith didn't pay her bill in full, by the due date. This means that the grace period didn't apply to her new purchase, so interest is calculated from the purchase date of January 5. (For an explanation of why the grace period didn't apply, see the section Determining If the Interest-Free Period Applies.)

Let's assume also that Mrs. Smith didn't buy anything on her credit card during February. When her February statement arrives, it shows a charge of approximately $41 in interest for the month, based on an annual interest rate of 18.5%. The daily interest rate of 0.05068%, shown in the calculations below, is the annual interest rate divided by the number of days in the year (18.5% ÷ 365).

	Average Daily Balance Method	Daily Balance Method
January 1 to January 4 - No transactions	$0 for 4 days	$0 x (0.05068%) = $0 $0 x 4 days = $0
January 5 to January 31 - Purchase of $3,000	$3,000 for 27 days	$3,000 x (0.05068%) = $1.52 $1.52 x 27 days = $41.05
Calculation of Average Daily Balance	($0 x 4 days) + ($3,000 x 27 days)          31 days in the billing period = Average daily balance of $2,612.90	Not applicable
Total Interest Charged1	Average daily balance x Daily interest rate x Number of days in the billing period = $2,612.90 x 0.05068% x 31 days = $41.05	$0 + $41.05 = $41.05

1. The average daily balance and daily balance methods generally yield the same interest charge.