How Your Credit Card Interest Charge is Determined

by : Joseph Kenny

Your credit card's interest rate isn't the only thing that affects how much you end up paying on your credit card bill, though it is a major determining factor. There is a difference between your interest rate and your interest charge. In simple terms, the rate is the percentage of your balance that your interest charge will be based on. The interest charge is the actual number of dollars that you pay for interest – based on your interest rate.

If that's confusing, this quick example can help illustrate the difference.

Balance – $1000

multiplied by

Interest Rate @ 18% or 0.18

Total Interest charge for the year = $180

If you've been paying attention, though, you'll have figured out that it really doesn't work to say that your interest charge will be $180 divided by 12 – because your balance will vary from month to month. So how do they figure out what you owe for interest on your credit card when the balance keeps changing?

There are three basic ways that credit card interest charges are determined. Your credit card company should state in its terms and conditions which method they use to calculate interest charged on your balance. They do make a difference, though it can be a subtle one for most credit card users.

Adjusted Balance

The credit card company starts with your balance from last month. They add in any charges for the month, subtract any payments and come up with an 'adjusted balance'. The adjusted balance is multiplied by the monthly interest rate (the annual interest rate divided by 12) to come up with your interest charge for the month. This method is generally most favorable to the credit card holder – that's you. If your balance at the start of the month was $200, and during the month you make a payment of $60 and charge $20, your adjusted balance at the end of the month is $160.

Average Daily Balance

Average daily balance is the most commonly used method of computing interest charges, and it's pretty even-handed, favoring neither credit card company or user. The credit card company keeps a running tally of your credit card balance day by day, adding in charges and payments as they come in and are posted. At the end of the month, all the daily balances are averaged to come up with a single figure, and the interest charge for the month is based on that figure. If, for example, your balance was $100 for the first 22 days of the month, and you charged a $500 computer on the 23rd day, then your average daily balance would be figured out based on (22×100) + (8×600) divided by 30 – an average daily balance of $233.

Previous Balance

Most consumer experts agree that this method of computing interest favors the credit card company, though it's certainly the simplest for them as well. They simply base your monthly interest charge on your balance at the end of last month (or the beginning of this, whichever way you prefer to look at it). If your balance at the start of the month is $400, and you pay $150 during the month, you will be charged interest on $400 this month. Next month, however, you'll be charged interest on $250, even if you charge $600 during the month.

Knowing how interest charges are figured can help you decide when to make major purchases while incurring the least amount of interest charge. If you know how and when the interest on your balance is computed, and can pay off charges within the time frame, your interest may end up costing you nothing at all.