How is Interest Calculated on Credit Cards?

It can be a jarring experience, to be sure. You review the list of transactions on your credit card only to find a sizable interest charge tacked onto your balance. If you’re wondering how banks actually determine that fee, you’re not alone. Here’s a step-by-step guide to calculating credit card interest, so you’re better prepared the next time you receive a statement. 

3 Steps to Calculate Credit Card Interest

While determining your interest charge may seem like mathematical wizardry, the process is actually pretty straightforward. The lender who issued your card uses three simple steps to figure out how much you owe. 

1. Calculate your daily periodic interest rate

Most credit cards have a variable interest rate, typically expressed as an annual percentage rate (APR). That percentage can change from one week to the next based on market conditions. 

However, most cards don’t use the APR to calculate your interest fee. That’s because they actually assess interest on a daily basis, even if it only appears once a month on your statement. Instead, they divide your current APR by 365 (or 360, for some cards) to come up with your daily periodic interest rate. 

For example, if your card has a 20% APR, your daily periodic rate would be .0548% (.20 ÷ 365 = .000548).

2. Calculate your outstanding balance

Fortunately, you don’t start paying interest right away when you make a new purchase. Credit cards provide a grace period of at least 21 days after each billing cycle ends. They only charge interest on the amount you haven’t paid off after that grace period ends. 

To calculate the interest charge, the issuer has to determine the amount of your balance that’s actually subject to interest. Card issuers have fancy software to handle all that math, which does get complicated. Suffice it to say that you only pay interest on the part of your balance—including amounts carried over from previous billing cycles—that have gone past the grace period. 

3. Multiply your balance by the daily periodic rate

Most lenders assess interest on a daily basis, even though it only shows up as a single line item on your monthly statement. To figure out the amount of interest you owe each day, the card issuer multiplies your balance subject to interest by your daily periodic rate. 

A compound interest formula determines how much you owe. In other words, the amount of today’s interest is tacked onto the balance used to calculate tomorrow’s interest. The upshot: You’re paying more than you would in the old days, when simple interest was the more common approach. 

Imagine, for example, that you currently have a $2,000 balance on which you owe interest. If you’re assessed interest of $1.10 for the day, the issuer will use your new balance of $2,001.10 to arrive at the next day’s interest. As a result, a card with a 20% nominal interest rate will have an effective interest rate that’s actually higher than that, thanks to the compounding. 

How does credit card interest work?

Credit card companies used to charge interest on a simple basis of once a month, but times have changed, and now the general practice is to charge it on a daily basis. As noted in the steps above, adding yesterday’s interest to today’s balance results in you paying more at the end of the month than the APR would indicate.

Interest rates on credit cards can be either fixed or variable. The latter are tied to an index and fluctuate with it. The former remain consistent and can’t be changed unless the card issuer gives you advance notice. Once a fixed rate does change, the new rate only applies to purchases made after the rate changed.

Keep in mind that banks and other card issuers may have more than one interest rate. For example, a card might have one APR for purchases and a different APR for balance transfers. Many cards also offer a low- or no-interest introductory period to attract new users. 

APR vs. interest rate

When it comes to credit cards, the terms “APR” and “interest rate” are more or less interchangeable terms, though, as noted above, assessing interest on a daily basis results in paying above the rate indicated by the APR. However, with some other types of credit, they describe two different things.

For example, the APR on a mortgage includes the interest rate the lender is charging you, but it also includes the annual charge you’re assessed for lender fees and prepaid interest. Therefore, the number is typically higher than the interest rate itself. 

Do credit card issuers determine interest rates?

The short answer is yes, credit card issuers determine the rate of interest you pay on your card. However, market conditions almost always affect how much they charge you, so the reality is a bit more complicated. 

How do card issuers determine interest rates?

The vast majority of credit cards come with a variable APR, which means the interest rate you pay can—and likely will—change over time. In most cases the APR is based on the prime rate, which is what the lender’s most creditworthy customers pay. The prime rate, in turn, is linked to a benchmark rate called the “federal funds rate,” which is set by the Federal Reserve based on prevailing economic conditions.

Credit card issuers will generally charge you an APR equal to the prime rate plus something called a “margin.” The amount of that margin depends on your credit score and borrowing history. If the bank categorizes you as a very low risk of defaulting on your payments, you’ll likely get a lower margin—and thus a lower APR—and vice versa. 

The American Express Gold Card, for example, has a range of “prime rate + 12.74%” to “prime rate + 19.74%,” based on the borrower’s credit profile. 

How can I lower my credit card's interest rate?

There are a couple of ways to potentially lower your interest rate. The first: Simply ask your current card issuer if it will lower your APR. There’s no guarantee that this will work, but doing your research helps. Your issuer may be more inclined to shave a few percentage points off if you can show other cards that are offering a lower rate. 

You’ll also improve your odds if you have a strong credit score and a history of making on-time payments. The interest rates banks charge are directly related to how much risk you pose as a borrower. Therefore, if you can prove that you’re a safe bet, they’ll be more likely to reduce the amount they charge you.

If that approach doesn’t work, you might be able to transfer your balance to a card with a 0% introductory rate. You may have to pay a fee—generally 3% to 5%—to transfer an existing balance to your new card, but you’ll still end up saving quite a bit, especially if you can pay off the balance before the promotional period ends. 

TIME Stamp: With credit card interest rates being higher, keeping a low balance is key

Credit cards generally have higher interest rates than other loans, which makes the size of your balance especially key to your financial health. Paying off as much as you can before your grace period expires will ensure that you minimize your interest fee. When shopping for a card, it’s smart to shop around to ascertain which are the best credit cards.

Frequently asked questions (FAQs)

When is the best time to pay?

Credit cards have a grace period after the billing cycle ends. For example, the Chase Sapphire Preferred Card has a grace period of around 21 days before the due date. You only pay interest on the amount that’s unpaid after the period ends. In order to avoid interest fees, be sure to make payments before it ends every month. 

What is 20% APR on a credit card?

“APR” stands for “annual percentage rate.” In theory, APR is the amount of interest you’d pay over the course of a year. 

Keep in mind that banks charge interest on a daily basis, which means they divide a 20% APR (0.20) by 365 (or 360, for some cards) to determine your daily periodic interest rate. Because most cards use daily compounding, most borrowers will pay an effective interest rate that’s higher than the APR. 

The interest you accrue today is added to the balance you pay tomorrow. So a card with a 20% APR will actually have an effective rate of 22.1%. 

How much credit card interest would I pay on $3,000?

If you have a card with a 20% APR that uses daily compounding, the issuer would multiply your initial $3,000 balance by the daily periodic rate (usually APR divided by 365). The issuer would then add that daily interest charge to your balance for the following day. That process would then repeat until you paid down the card. 

On a $3,000 balance, you’d pay $664.01 in interest for the year. Of course, the higher your interest rate, the more you’ll be charged. A card with a 25% APR, for example, would assess $851.75 of interest over the course of a year. 

In the real world, your balance would fluctuate over time because of payments or new purchases. For the sake of simplicity, the above illustration assumes that you don’t have to make minimum payments on your card.