How Is Interest Calculated on Credit Cards ?

Ever wondered how is interest calculated on Credit Cards ? Despite the many perks a Credit Card provides, you’ve often been warned against racking up a huge debt on it. Cards have steeper interest rates levied than personal or auto loans, and if you’re not warmed up to the rules of this number game, you can easily find yourself tangled up in a vicious cycle for years.

We’ve tried to demystify how interest is calculated. Let’s take a look:

Billing Dates and Due dates

Before we get into understanding the method of interest calculation, let’s take a look at the billing cycle of a Credit Card. When you’re applying for a new Credit Card, typically you get to choose one date (out of a couple of options) for when your bill should be generated. Say you chose the first of every month as your billing date, you get an additional 15 to 25 days to pay the bill, i.e. by your due date.

Maximizing Interest-Free Days

In the UAE, banks offer a maximum of 45 to 55 days as a grace period in which you are not charged any interest. How many days you get in reality depends on your date of transaction. This is the first spot where there’s scope for increasing your benefits. By choosing the most optimum day in your billing cycle to make purchases you can avail the highest grace period.

For example:

You receive the card on 28th November:

If your billing date is the 1^st of every month, you’d get the longest grace period by making your purchase on 2^nd December (since the bill generated on 1^st December would have zero outstanding, and you’d then get the entire 30 days of December till the bill is generated on 1^st January plus 15 days till your due date on a card that offers 45 days of grace). But if you make a transaction on 1st December, you get the shortest grace period of 15 days.

As long as you keep paying your outstanding balance in its entirety by your due date, you won’t attract any interest and will keep enjoying the grace period benefit. However, the minute you carry forward any balance to the next month, the bank starts earning interest on it on a daily (Yes, DAILY!) basis.

Calculating Interest Using Average Daily Balance

The key to bringing down or eradicating your Credit Card interest is to recognize how it is computed.

If the monthly interest rate mentioned for your Credit Card is of 2.99% of the outstanding balance, can we simply say that if you made total purchases of AED 1,000 on your Credit Card in a given month, your interest amount would be AED 29.9 ……?

Not necessarily.

In reality, you may not have spent AED 1,000 on just one particular date. It may be spread out over a couple of dates in numerous small amounts. Since you make many transactions at different times during your billing cycle, your balance amount fluctuates on a daily basis. Hence, to make things easier, banks look at the number of days any given balance is carried for, and the amount you owe is leveled out over the month to arrive at an “average daily balance” (ADB).

For instance, if you use AED 100 on the initial day of a one month period, then your ADB would be the same. But if you swipe for the same amount on the final day of the billing period, your ADB will be only AED 3.33 (100 multiplied by 1 day, divided by 30). So the formula for ADB = Given balance X No. of days it’s being carried / No. of days in the month.

Every time you make a new transaction on the card, the average daily balance gets adjusted. Finally, all the average daily balances are added up and then the monthly interest rate is applied to it.

Let’s try an example:

STATEMENT 1: Date 1^st January

(Based on an AED 1,000 purchase on the first day of the billing cycle)

So, the Minimum due amount is (5%): AED 50

Due date: 15^th January

Let’s say you only pay the minimum amount by your due date.

And then you make another transaction of AED 500 on 15^th January.

STATEMENT 2: Date 1^st February

Minimum due: AED 74.34

Due date: 15^th February

The interest of 36.87 may look like a small number, but don’t be fooled.

Just remember two words – Interest compounds.