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When you look at your credit card statement each month you may notice your purchases are charged interest. If your credit card has no grace period you’ll notice this interest begins to accrue as soon as you make the purchase; credit cards that do have a grace period, on the other hand, allow you a set period of time before interest begins to charge on the remaining balance. Here’s a guide to understanding how your credit card APR is calculated each month.
To begin with, every credit card company uses a different way to calculate APR; there is no rule that applies to all card issuers when it comes to your APR. It’s required by law for your credit card company to provide you with a notice about changes to and information regarding your interest rate, along with a statement telling you which method they will use to calculate the interest on your account. These statements will almost always come with your credit card when you first receive it and often come in small booklets. You’ll also receive a new statement with updated information in the mail whenever changes are made to your terms.
The calculation of your APR has two main types: fixed and variable. If you have a fixed rate–and only about 15% of credit cards have a fixed rate–you will have an interest rate that doesn’t go up and down with the economic climate; it will remain what it was when your account was opened. Variable interest rates, on the other hand, are based on the prime rate plus an extra percentage that’s selected by the bank based on your credit history. Variable rates can change dramatically and can also change depending on the economy.
To get your monthly interest rate, your card issuer will divide your APR–or annual percentage rate–by twelve, the number of billing periods in a year. For example, a 15% APR divided by 12 will give you a periodic rate of 1.25%. This periodic rate is then multiplied by your outstanding balance. Unfortunately, determining how much you’ll pay in interest can become complicated. Here’s an explanation of the methods credit card companies use to determine exactly how much of your outstanding balance is charged the periodic interest rate.
1. Adjusted balance
This is the best way for the consumer to have their interest calculated because it will reflect any payments you’ve made during the month. It also doesn’t increase the balance you owe by purchases you’ve made within the same billing cycle. For example, if you have a balance of $1,000 and make a payment of $500 and charge $100 during the month you will only be charged your periodic rate on $500.
2. Average daily balance
This is one of the most common methods used to calculate interest and means the balance is determined by adding all balances on every single day of the billing cycle and dividing by the number of days to get an average daily balance on your account. All purchases are added and payments are subtracted.
3. Two-cycle average daily balance
This is one of the worst ways to have your balance calculated because it doesn’t account for payments, a particular problem if you’re making large payments to pay down your balance. The balance on your account on each day of the last two billing cycles are added up and then divided by the total number of days to give this two-cycle average daily balance.
4. Previous balance
If your credit card company uses your previous balance to figure your interest they’re applying your periodic interest rate to the balance at the beginning of the billing cycle. No purchases or payments made that month will affect anything.
5. Ending balance
Lastly, the ending balance calculation only uses the balance at the end of the billing cycle to determine your interest. All payments and charges don’t affect the calculation unless they change the ending balance. This method is particularly tricky for consumers because you can never be sure which day they are picking to be the end of the billing cycle.