Credit card billing practices are complicated, and their nuances are enough to give most people a major headache. Let’s see what we can do to change that.
Every credit card – save for charge cards – has an Annual Percentage Rate (APR). An APR technically isn’t the same thing as an interest rate, but they are closely related.
To calculate the interest you’ll be charged on a daily basis when revolving a balance, simply divide your APR by 365 and voilà, you’ve got it. In other words, if your APR is 15%, you’ll be charged interest on your outstanding balance at a daily rate of 0.41%. Your outstanding balance includes any interest that was previously assessed. That means you pay interest today on not only your principal balance, but also the interest you were assessed yesterday, the day before that, etc.
Finance charges are therefore applied to your average daily balance over the course of a billing period. In other words, if you have an existing balance and continue to make purchases throughout the month, the amount that incurs finances charges will be greater than the original balance held at the beginning of the billing period.
Banks will not charge you interest if you do not carry a balance from month to month, otherwise known as a revolving balance. You don’t have a revolving balance if you have paid the full amount printed on your last two bills by the due date.
In other words, when you have satisfied the above requirement, most credit card companies will offer a no-interest grace period of around 25 days from the date your bill becomes available to when you need to submit payment.
We often receive questions from bewildered consumers who receive a bill that includes finance charges after they’ve brought their account balance to zero. They typically assume (or simply hope) that their credit card company has made a mistake that can easily be corrected without them having to pay any more money.
While that might end up being the case in certain situations, the confusion is most often a result of misunderstanding the credit card billing process as well as how finance charges are calculated and ultimately assessed.
So, let’s see what we can do to set the record straight, starting with a practical example.
Say that you didn’t pay your last month’s bill in full and you owe $500 when your next month’s credit card statement becomes available on June 1st. While you may have until June 30th, for example, to submit a payment before it’s considered late, interest will be assessed based on the average daily balance in the interim. In other words, the amount that you owe will increase with each passing day.
So, even if you pay off the full $500 balance by the due date (June 30th in this example), you’ll still owe money for the daily finance charges that this $500 balance incurred since June 1st. As a result, when your new bill becomes available on July 1st, your balance will be equal to the finance charges incurred the previous month. If you do not pay this amount, you will incur interest on interest and will continue to do so until you have paid two consecutive bills in full and therefore regain your grace period.
What can you take away from this example?
The perhaps confusing distinction between your original balance and the finance charges that accrue on top of it underscores the importance of carefully reviewing your monthly credit card statements. Doing so, rather than simply taking a quick glance or throwing the statement in the trash sight unseen will enable you to spot unanticipated charges as well as raise questions about potential mistakes.
As mentioned at the outset of this article, it is possible for a credit card company to misstate a charge or balance on your account. But if you don’t notice it and therefore sound the alarm, then you’ll likely end up paying it in error or have interest accrue and the situation grow more complicated over time.
Paying off what you spend using a credit card every month is obviously the best way to avoid being charged interest, but it’s not the only one. There are also a few tricks you can use to ensure that finance charges won’t show up on your account. We’ll explain them below.
While understanding how banks calculate interest can be helpful, it’s not a prerequisite to understanding that debt can be detrimental to your finances. Not only is interest expensive, but it can quickly become unmanageable, causing you to miss payments and incur credit score damage.
Keeping a budget, regularly reviewing your spending habits, and avoiding unnecessary debt are therefore essential to responsible money management.
Still, if we as a society are going to make true strides, we must seriously address our financial literacy (or lack thereof). This applies to the way in which interest is calculated, across the breadth of personal finance, and involves everyone from parents to the financial service providers themselves. “Schools should also offer basic practical education,” says Randall Bartlett, a professor of economics at Smith College. “The power of compounding is most important for the young to understand….and most don’t ever figure it out…out do when they are 55 and it is too late.”
