FINANCIAL FRESHMAN #019
TL;DR → Most credit cards in 2024 apply interest using the average daily balance method. In this approach, your “daily periodic rate” and “average daily balance” are used to calculate the interest that will be applied after your billing cycle concludes.
Introduction
In last week’s post, we dove into the basics of credit card interest and highlighted some things you can learn from your statements. Our math was fairly straightforward, since we made the big assumption that no additional purchases were made as we worked to pay off the balance. Under this condition, calculating interest was as simple as applying your card’s APR to a balance over time.
In this post, we’ll provide an example of how credit card interest is going to be applied in the real world.
A Quick History Lesson
Remember when you first opened your credit card, and you received a giant packet of information in the mail? That was your credit card agreement – don’t worry, we didn’t read ours either. Fortunately, the Consumer Financial Protection Bureau (CFPB) maintains a database of hundreds of these agreements, so you can go here and search for your credit card if you’d like.
From this agreement, we’re most interested in learning how interest is applied to your specific card. In the world of credit cards, there are a number of ways that interest can be calculated and applied. There was a time when you needed to know if your card used the “ending balance method,” the “previous balance method,” or the “daily balance method,” just to name a few.
Fortunately, the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009 made some of the more predatory interest practices illegal, including the “Two-Cycle Average Daily Balance method.” Remember that “minimum payment warning” we highlighted last week? You can also thank the CARD Act for making it a required feature on every statement. Thanks, Obama!
One Method to Rule Them All
Let’s check the CFPB database for agreements for a few popular credit cards. Within each agreement, we’re looking for the section that explains how our interest is calculated.
Here’s a quick screenshot from that section for an AMEX, Capital One, and a Wells Fargo card.
These example agreements highlight that, in recent history, one interest calculation method has risen in popularity so much that it has almost become standard: The Average Daily Balance Method. If you understand this method, you’ll be able to quantify just how damaging it can be to let credit card spending get out of hand.
Let’s run through an example of how this method works.
The Average Daily Balance Method
Applying the Average Daily Balance method to your credit card ledger is admittedly a bit complicated. Breaking it down into these three steps will help keep us organized.
#1 → To calculate our DPR, let’s use the same 19.90% APR from our example credit card from last week. This is as simple as dividing this rate by 365 days.
#2 → From here, we can look across our entire month of spending and calculate our average daily balance. To keep things simple, we are assuming our billing cycle is the entire month of December.
#3 → The last step is to apply a formula to calculate the interest that will be applied at the end of this statement. In this case, “Days” refers to the number of days in your billing cycle.
With this spending on a card with this interest rate, one would accrue $14.31 in interest across this billing cycle.
Final Thoughts
Will you actually sit down to do this math every month? Definitely not. What you should do, however, is keep in mind that unchecked credit card use can be especially risky. Interest only shows up on your statement once per billing cycle, but remember that it is quietly accumulating in the background every day.
Understanding this method helps you stay in control of your credit card use, and will prevent a surprisingly large bill at the end of the month.
