How Credit Card Interest Is Calculated
When choosing a credit card many people look at the interest rate, but fewer people consider how the interest is actually calculated and applied to the card.
There are numerous ways that interest is calculated and charged on credit cards. Most of us know that there are some cards which charge interest from day one and others that give up to 55 days interest free, however there are other differences between the various credit card providers.
A basic credit card will have no interest free period, and interest will be charged from the time you make a purchase or cash advance. This is the most straightforward method of interest calculation used for credit cards.
Depending on the card, there may be complications when it comes to cash advances and balance transfers. These issues will be covered further in this guide.
Interest Free Cards
An interest free credit card gives you a period of up to 55 days where you are not charged interest on purchases. Although a card may offer 55 days interest free, this does not mean that all of your purchases will receive the full 55 days interest free.
Interest free credit cards work by not charging you any interest on purchases made during the monthly billing cycle, and still not charging you any interest during the 25 day period following your statement date that you have to clear the balance on the card.
Purchases made on the first day of the billing cycle will receive the full 55 days interest free, however this will reduce for all subsequent purchases as you approach the end of the monthly billing cycle.
But there is a catch. In order to avoid paying any interest on your credit card you must clear your full monthly balance by the due date each month. If you do not clear the balance you will be charged interest on the full amount. Not only that, but the interest will be charged all the way back to the first day of each individual purchase!
If you have a month where you do not clear the balance and are charged interest on your credit card, it can often take another full monthly billing cycle before your card reverts to interest free, and that’s only if you repay the full balance before the next due date.
Regardless of whether you have a basic card or an interest free card, cash advances will always start accruing interest from day one. A cash advance will also attract a higher rate of interest in many cases, and will generally also cause an interest free card to revert to full interest mode.
Credit card balance transfers can be a great way to reduce your interest bill, however they can impact on the way you use your card, especially if it is an interest free credit card.
If your balance transfer is going to result in carrying a balance on your credit card for a number of months, any interest free period will be nullified on your card and it will not be regained until the balance has been repaid in full.
How Payments are Applied
Complicating all of the above is the way in which the credit card providers apply your repayments to the account.
A number of credit card providers will apply your repayments to whichever balance has the lowest interest rate.
For example you may have a card with $1,000 owing from a balance transfer being charged 5% interest, and another $1,000 owing from a cash advance being charged 20% interest.
In this example the credit card provider may apply all of your repayments to the balance transfer at 5% interest, whilst the cash advance will remain at $1,000 being charged the higher interest rate.
Thankfully a number of banks have now changed their policy to ensure that repayments are always applied to the highest interest balances, however you should definitely check this on any credit card you have or are applying for.
Comparing interest rates is certainly important when choosing a new credit card, but you should also consider the way that the interest is charged before deciding on your next card.