How does Interest of a Credit Card Work and How APR is calculated?

As per a study conducted amongst the American credit card holders, more than 50% of them carry a balance on their credit card payments. If you are one among those millions of credit cards users, you may have certainly noticed how fast the interest charges change on your monthly credit statements.

Do you exactly know how these charges are getting calculated? Do you remember all the facts about the credit card terms and conditions you agreed upon while applying for the credit card? Are you capable of making the best financial decisions about yourself and your family with the use of credit cards? If all these questions are there in your mind, here are a few things you need to know about credit cards interests and APR calculations.

The concept of APR

All the credit cards are subjected to a standard interest calculation which is known as APR or Annual Percentage Rate. This number may vary from provider to provider and also from user to user based on various factors including the individual credit scores. APR is usually expressed in terms of yearly payments, but many leading credit card providers used to calculate this charge over their monthly statement period. So, similar to the “miles per hour” as the way to measure a vehicles speed against time, APR can measure the interest over a particular credit card debt over a year’s time period. However, in both these cases, this particular measurement is used for both longer- and shorter-term periods.

How is APR calculated?

In order to find the interest rate you are paying on your credit card balance each day, you have to convert the APR into a daily percentage ration. In order to get it, divide your set APR by 365 (number of days in a year). For each day with a pending payable amount in your account, the issuer will multiply the existing balance with the daily rate to calculate the interest charges on a daily basis. This will be added to your balance and carried over to the next day, which is called compounding.

If you are wondering how much it may cost you to own carry a credit card balance? You need to first enquire about your personal APR. The higher your APR is, the more interest you have to pay on carrying over a balance. The formulas of various credit card providers may vary, but most of the top credit card issuers will be calculating a periodic rate and average monthly balance in order to calculate the interests. You can do these calculations all by your own, let’s walk through the standard process of calculating the interest charges on your credit card/s.

Types of APRs

There are two major types of APR calculations credit card issuers may follow. Some of the credit card providers may calculate their receivables with a variable APR, and some others may be taking a fixed-rate APR. You may also get offers like enjoy 0 percent APR on all purchases of at least 299 dollars etc.

  • The variable rate APR credits will have an interest rate which is tied to a reference index like the U.S. prime rate. In terms of any fluctuations in the U.S. prime rates, the interest rates of the variable rate credit card issuers also will change accordingly. The credit card interest rates with a variable APR could change bimonthly, monthly, quarterly, or yearly. You may know it by going through the credit card terms and policies documentation. You may check it with the support service also as to how the APR is calculated.

 

  • Interest rates of the fixed-rate APRs may not change with any index. However, fixed rates may still change, but the card issuer should give you enough notice period before initiating the change. The CARC (Credit Card Accountability Responsibility and Disclosure) Act of 2009 mandates the credit card agencies to give a minimum notice period of 45-days to implement any changes in the interest rate. Before the CARD mandate, it was only 15 days notice.

As we had seen above, even though APR is an annual rate calculation, it is not charged annually by the credit card issuers. They will make corresponding calculations for daily and monthly basis in order to determine how much to be charged. In order to decide this, you need to use the formula of daily periodic rate.

Calculating the daily period rate

Te calculates DPR or Daily Periodic Rate, you have divided the APR by 365. There are some important things to note while doing this. Some of the credit card companies may use 360 instead of using 365 to divide the APR value. You have to check it out with the individual card issuers to ensure the correct number. Each credit card activities like balance transfer, purchases, and cash advance may have different APRs. So make sure that you use the correct APR for the balance in order to get proper values.

Once you divide the APR with the corresponding days, you get the DPR. This number has to be multiplied with the amount balance in your credit card payment to get your interest for each day. This daily amount will be added to your lump sum payment at the end of the billing cycle. This is considered as your capital amount plus interest chargeable for the month.

Average daily balance

Another big challenge in calculating the interest on your credit card balance is that the balance amount may change several time over the course of a month. On the first day of the month, you may have a debt of $1,000 by if you spend another $50 on the tenth day of the month, then your balance will go up to $1,050. You balance may also go down if you make some payment in between.

To take up this effectively, credit card issuers use the concept of average daily balance to calculate the interest charges. This is primarily the average of balances on a daily basis which you owe over the entire billing cycle. In order to calculate the average daily balance, you need first to write down the balance you owe at the end of each day and then find the average of all those.

For example, if you owed $1,000 for the first 15 days and then $2,000 for the next 15 days, then the average daily balance can be taken as $1,500. The issuer will be calculating your DPR based on this number to find the interest.

All these calculations affect your financial well-being and monthly budget on owning a credit card. So, it is important to understand these calculations well at the first point itself before availing a credit card and start to use it.