Credit card interest rates are set yearly, but calculated monthly. Some credit card interest may be calculated daily and charged monthly. For example, let's say your card has an APR of 18%. If your total purchase is about $100 with tax, it would cost you approximately an additional $18 in interest if you choose to stretch your payments over a full year, and you do not charge additional purchases on top of your balance. And if your card "compounds" the interest (a practice of charging interest on the monthly interest accrued), the total interest will be several dollars more than the annual rate.
To calculate your monthly interest charge, the bank takes the 18% APR and divides it by 12 months for the year. That comes to 1.5% of the average daily balance for the month.
The average daily balance is a method of leveling out the amount you owe, which may fluctuate from day to day because of payment and purchases. The calculations to determine average daily balance sound complicated, but they're really rather simple.
In effect, the bank adds together the balance on your credit card for each day of the month, and divides the total by 30, the number of days in the month. For a more complete explanation of how the average daily balance is calculated, see the chart.
Yearly Rate = 18%
Monthly Rate = 1.5%
(Based on a $100 purchase on the first day of the billing cycle)
Previous/beginning balance = $100
Balance subject to finance charge = $0
Finance charge = $0
Payment made 25 days into cycle = $50
Previous/beginning balance = $50
Balance subject to finance charge
($100 x 25 days/30 days = $83.33)
($50 x 5 days/ 30 days =
(1.5% of $92 = $1.38) = $1.38
($50 + $1.38 = $51.38) = $51.38
Let's say you decide to pay the $100 charge for your dress in two monthly payments of $50. You receive your credit card statement and see the charge listed. Approximately three weeks after you receive your statement, you mail in your payment of $50. It arrives at your bank 25 days into your credit card cycle. You make no additional charges and next month's credit card statement arrives.
You see your previous balance of $50, an interest charge of $1.38, a balance subject to finance charge of $92, and an ending balance of $51.38. Meaning the total cost of purchasing the dress, assuming you pay the ending balance in full, is $101.38.
But how did the bank arrive at $1.38 in interest?
If you had paid the $100 charge in full by the due date on the statement, you would have paid no interest, leveraging the bank's "grace period" - generally 14 to 25 days from the date of purchase. But because you paid only $50, interest is accrued from the date of purchase using the average daily balance method.
So in calculating the average of your account's daily balance, the bank looks at the number of days carrying any given balance. Since your first $50 payment was received 25 days into the credit card cycle, you carried a balance of $100 for 25 days ($100 x 25 days divided by 30 days in the month = $83.33, the average daily balance for 25 days).
If you add both average daily balances from above, you get your balance that is subject to a finance charge of $92. Therefore, the 1.5% (the monthly interest rate) of $92 is $1.38, your interest charge.