It’s no mystery that credit card companies charge interest on outstanding balances. And most credit card users are at least nominally familiar with their credit card’s APR (annual percentage rate). You carry a balance, you get charged interest — simple enough.

Beyond that, things start getting a little murky. How is your APR determined? How do interest charges get calculated? And at what point does your balance start accruing interest charges anyway?

 

Confusion spells costs when it comes to credit card use. It’s hard to avoid paying interest if you have no clue how and why it’s being charged in the first place.

So if you really want to minimize the cost of credit, you’ll have to understand how exactly credit card interest makes its way onto your monthly statement in the form of a finance charge.

The interest-free grace period

Our journey through the life cycle of an interest charge begins on the very first day you get your credit card in the mail. It’s new, it’s shiny, it’s a spotless receptacle for all your hopes and dreams. It has a 20% APR.

You decide to finally take your new card for a spin and use it to make a $100 purchase. Now, most cards afford you a “grace period”—between the billing cycle close date and the payment due date—during which no interest is accrued on your balance.

So if you charge $100 to your credit card on the 1st of February, the billing cycle closes on the 24th, and the payment due date is on the 21st of March, you have from Feb 24th to Mar 21st to pay your $100 balance off in full without paying any interest. That 20% APR is a total non-factor.

Pay your balances off in full each month and you retain the grace period from the end of each billing cycle to the start of the next one. This is the sweet spot. As long as you don’t carry over a balance into the next billing cycle, you’ll continue to enjoy the interest-free benefits of the grace period.

Revolving a balance—when the grace period is over

Let’s say that instead of paying off the full $100, money was tight and you could only make a $20 payment. The moment you begin to “revolve a balance” by carrying an unpaid balance over into the next billing cycle, the grace period ceases to apply and interest is assessed on your unpaid balance and any new purchases you make.

That remaining $80 balance will begin to accrue interest as soon as the next billing cycle begins. Plus, any new purchases you make will start accruing interest the very day the purchase was made. This is when that 20% APR becomes a factor.

How interest charges are calculated

Figuring out how much interest you’ll be charged isn’t as simple as applying the APR to your balance. Interest accrued throughout the month will show up as a finance charge on your monthly statement. So how do get a monthly charge from an annual interest rate?

Since interest on your balance accrues daily, the first thing you’ll need to know is the daily periodic rate. You can get this by dividing the APR by 365. Our 20% APR ÷ 365 = 0.054%

From there you’ll need to know your average daily balance. Since your balance may vary throughout a given billing cycle, credit card issuers apply the daily periodic rate to the average balance on your account for every day of that billing cycle.

So let’s say we pay off half our $80 revolving balance on the 15th day of a 30-day billing cycle. Our average daily balance would come out to (15 × $80 + 15 × $40) ÷ 30 = $60.

Now we have all the pieces to use the basic formula most credit card companies use to calculate your interest: Average daily balance × daily periodic rate × days in billing cycle = your monthly interest charge.

Our $60 average daily balance × our 0.054% DPR × the 30 days in the billing cycle = $0.972 in interest.

Yes, all that math for a mere $1 finance charge on your monthly statement. But it’s easy to see how that interest could pile up with a larger balance. Carrying an $800 balance? That’s a $10 finance charge. An $8,000 balance? You can add a whopping $100 finance charge to your statement.

Plus, since interest is accrued on your balance daily, it compounds the longer you don’t pay your balance off. A revolving balance can quickly balloon if you let your interest get out of hand.

Regaining the grace period and avoiding interest

If all the above is enough to make your head spin, it’s probably best to circumvent the interest life cycle altogether. Of course, carrying a small balance and paying a small interest charge from time to time isn’t going to cripple you. But if avoiding any and all interest is really important to you, you’ll have to make use of the grace period.

Retaining a grace period while you have it is easy—just pay your balance in full, on time, each month. Reinstating the grace period once you’ve lost it can be a little trickier. Here are a few things you need to know if you want to get back in the good (interest-free) graces of your credit card.

  1. The grace period only applies to purchases. More often than not, cash advances and balance transfers start accruing interest right away. To add to that, they have their own APRs, which are normally higher than the purchase APR. There are plenty of good reasons to transfer your balance, but if you’re set on avoiding interest, it’s best to stay away from cash advances and balance transfers.
  2. Regaining the grace period requires a $0 balance. Even carrying a $1 balance is enough to waive the grace period. Paying interest on a $1 balance amounts to virtually nothing. But what if you plan on making a larger purchase? Remember, without the benefits of a grace period, new purchases start accruing interest right away. So a $1,000 purchase early in the month will gather up enough interest—even if you pay it off in full by the payment due date—for a not-insignificant finance charge on your monthly statement. Avoiding interest charges requires regaining that coveted grace period, and that requires bringing your balance down to $0. Some credit cards might require you to have no revolving balance for two full billing cycles before reinstating the grace period.
  3. Beware of “trailing interest.” Here’s yet another layer of complexity: it’s possible to pay the full balance amount shown on your statement but still receive a finance charge at the end of the next billing cycle. And that finance charge, as little as it may be, can keep you from regaining the grace period if carried over into the next billing cycle.

This is due to “trailing” or “residual” interest. Basically, in the time it takes for you to receive the statement from your last billing cycle and fully pay the balance off, some interest will have accrued. Say your billing cycle closes on Feb 24th, and you receive your statement in the mail a few days later. Even if you pay the balance off in full right away, those few days it took for you to receive the statement will have added to your balance without you even knowing.

One possible solution is to fully pay your balance off online on the day your billing cycle closes. That way you’ll have paid any finance charges for that cycle as well as your full balance. Of course, it also never hurts to simply call your credit card issuer and directly ask how you can reinstate the grace period.

To sum up

If you don’t want to pay interest, pay your balance off in full each month within the grace period. If you’re carrying a balance and want to regain the grace period, pay your balance down to $0 for two full billing cycles.

And don’t sweat it if you happen to carry a small balance month-to-month. Paying a dollar or two in interest charges here and there isn’t the end of the world. Just remember to regain the grace period if you decide to make a major purchase so you avoid paying interest right away on a large balance.

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