When you make a purchase using a credit card the bank pays the store for you, based on the promise that you’ll pay them back later, plus interest. If you pay off the balance in full every month—you’re left with no additional cost owed. But things happen, and some months you may be unable to pay off your balance. That’s when you’re charged interest. So how is interest calculated? What’s residual interest? And how often is it charged?
Many credit card companies calculate interest using a method called “average daily balance.” Basically, at the end of each day in a billing cycle, the credit card company writes down your current balance (if you have a grace period, new purchases won’t be included in that daily sum). At the end of the cycle, it adds up all those balances. For instance, the total of all your end-of-day balances might equal $30,000. That’s not your debt, though—if you spent around $1,500 with your card during the cycle, you could easily have that amount in total daily balances.
total daily balances = $30,000
Then, the credit card company divides that total by the number of days in the cycle to get your average daily balance. In this example, your average daily balance would be $1,000.
$30,000 total daily balances ÷ 30 days
$1,000 average daily balance
The credit card company then determines a number called a daily periodic rate, which is your annual percentage rate (APR) divided by 365. Say you have an APR of 15%. Your daily periodic rate would be .041%.
15% APR ÷ 365 days
.0411% daily periodic rate
Take the average daily balance and multiply it by your daily periodic rate and you get the daily interest amount. In this case, 41 cents.
$1,000 average daily balance × .0411% daily periodic rate
$0.41 daily interest
In this example, at the end of the 30-day billing cycle, your total interest charges would equal $12.30.
$0.41 daily interest × 30 days
$12.30 total interest
For specifics on how your credit card company charges interest, refer to the terms and conditions of your card account.
Residual interest is interest that’s charged between when a credit card bill is sent and when your payment is received. If you pay your balance in full every month, then all your purchases get grace and you don’t have to worry about residual interest.
If you carry a revolving balance—meaning that you don’t pay your entire monthly balance—you’ll be charged residual interest on the balance you carried over from the previous month, even if you pay it in full that month. Plus, since residual interest is accumulating after your statement is sent, you won’t see it on the bill. In fact, even if you pay that statement in full, you might still owe some residual interest.
Remember, if you want to avoid interest altogether, the simple solution is to pay off your balance in full each month.