Ever wonder why one month you get your credit card statement and your interest charges are surprisingly low, and the next month they’re higher than you expected? There’s a reason for that.

When do you pay interest

When you make a charge on your credit card you have 21 days to pay the credit card company back WITHOUT incurring an interest charge. This interest-free time is called a grace period. If you pay it back after that 21 days, you’ll have to pay interest for every day after the charge was made. This is good news to those who are tight for cash until their next paycheck a few days away, and for those of us with credit cards that carry a steep interest rate, some as high as 24.99%, or higher! Paying off your credit card during the grace period means interest-free debt AND being able to cash in on any rewards tied to your particular card (cash back, travel points, airmiles, etc.)

But what if you don’t pay off your debt before the end of the grace period and instead carry a balance? This is when you start to accrue interest. You will be charged interest for the following reasons:

  • carrying forward the balance of previous purchases
  • cash advances (withdrawing or transferring amounts from your credit card)
  • balance transfers (moving debt from one credit card to another)

Annual Percentage Rate

On your credit card statement you’ll find details specific to your card. These include your credit limit, available balance, minimum payment amount and due date, as well as the annual percentage rate (APR). This may also be simply called the interest rate. The APR is the rate of interest you will pay on balances carried over. Other charges will likely accrue interest at different rates. (Check your credit card agreement or contact the credit card company for details. An information phone number is often provided on the back of your card.)

The “annual” in APR means that you take your interest rate and divide it by 365 days to get your daily interest rate. This is how much interest you’ll be charged at the end of each day.  For example, lets say you have a credit card with an interest rate of 19.99%. 19.99% ÷ 365 = 0.05476712% interest charged per day. Lets say you made a $500 purchase on March 1st and paid it off 30 days later. You would pay the original $500 plus $8.22 in interest. (More below on how this is calculated.)

The danger in minimum payments

The minimum payment is the smallest payment your credit card company requires you to pay in any given pay period. This amount is often quite small, usually about 3% of your total balance. The consequences should you not make at least the minimum payment can be severe. The company can freeze your card, making it unavailable for use, or jack up your interest rate. Making minimum payments can be a godsend when you’re temporarily hit a financial snag, but it isn’t good for the long-term. You’ll notice that your credit card statement may include a “minimum payment timeline.” This is an outline to how long it will take you to finish paying off your credit card balance should you only make minimum payments. Depending on your balance and your interest rate, this timeline can be months, years, or even decades!

What does this look like in real life?

The average Canadian has $4,154 in credit card debt, according to the credit agency TransUnion. Using this credit card payment calculator, the minimum payment on this debt would be $124.62 and would take 19 years and 9 months to pay off completely (based on an APR of 19.99%)……. Does this bring Andy Dufresne and his rock hammer to anyone’s mind, or just mine? Check your own credit card statement to find out how long your minimum payment sentence is.

In this scenario, not only would you have spent nearly two decades shackled to this relatively small amount of debt, but you’d also have paid $4,927.59 in interest by the time you were through. That’s MORE than the original balance! A balance which will have effectively cost you 118.62% in interest! With this in mind, it’s obvious that minimum payments should always be used as a short-term or last resort.

Note: If you do not receive a statement in the mail from your credit card company each month you are likely receiving an electronic statement. If you have not received an e-statement either, we recommend you sign in to your bank account online and look for your statements there. You can also visit your local branch and ask for details. It’s also a smart idea to review your statements each month for notifications, updates, and changes to the terms of your contract. For example, your interest rate can jump significantly, particularly if you’ve missed two or more consecutive payments.

How is monthly credit card interest calculated?

The amount of interest you are charged each month is calculated in 4 steps. Lets go back to our example of a $500 purchase and pretend you made another purchase of $100 on March 3rd, but no other purchases for the rest of the billing period (which we will pretend starts on the 1st of every month.)

  1. Calculate the average daily balance. This is done by adding up each daily balance of the billing period and dividing it by the number of days in that billing period.
    • (day 1 balance + day 2 balance + day 3 balance etc.) ÷ number of days in the billing period = average daily balance
    • Ex. (500 + 500 + 600 etc.) ÷ 31 = $593.55
    • Ex. OR ((500 × 2) + (600 × 29)) ÷ 31 = $593.55
  2. Calculate the average daily interest rate. The company finds this rate by dividing the card’s APR by the number of days in the year.
    • APR ÷ 365 = average daily interest rate
    • Ex. 19.99% ÷ 365 = 0.0547%
  3. Calculate the periodic interest rate. This is done by multiplying the average daily interest rate by the number of days in the billing period.
    • average daily interest rate × days in billing period = periodic interest rate
    • Ex. 0.0547% × 31 = 1.6957%
  4. Calculate the monthly interest payment. This amount is determined by multiplying the average daily balance by the periodic interest rate.
    1. average daily balance × periodic interest rate = monthly interest payment
    2. Ex. $593.55 × 1.6957% = $10.06

Based on these calculations you will be charged $10.06 in interest for your billing period in March.

Other interest charges

As mentioned earlier, you will also be charged interest for other transactions such as cash advances and balance transfers. These types of charges do not have a grace period and will be charged interest from the day you made the transaction. The interest rate on these kinds of charges are often higher than your APR.

What to do

Credit cards are a great way to build your credit score, but also a great way to get into a heap of debt if you don’t plan ahead. Credit cards are useful for short-term purchases you plan to pay off within the interest-free grace period, or shortly thereafter. If you anticipate making a purchase that will take longer than this to pay in full, we recommend using a line of credit. Lines of credit often have much lower interest rates compared to credit cards.

For more information on credit card debt, lines of credit, or debt consolidation, please contact us today.