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Credit card interest is typically compounded daily, which means your credit card issuer charges interest to your account each day based on its average daily balance. The larger your balance grows, the more interest that will be added on top of the amount you owe.
Compounding interest can lead to a swift accumulation of interest charges and make it more expensive to carry a balance on your cards. That's why it's important that you aim to pay off your balance each month. Credit card issuers won't charge you the interest that has accrued if you pay your statement balance in full by the due date.
Here are the basics on credit card interest and how it's compounded so you can avoid paying more than you need to.
What Is Compound Interest?
A helpful way to think about compound interest is to compare it with its counterpart—simple interest. Simple interest takes a percentage of the total balance (the annual interest rate), and adds it to what's owed (the principal). For example, with a $100 loan that has a 5% simple annual interest rate and a three-year term, you would ultimately pay back $15 in interest in addition to your $100 principal balance. You might use this type of interest formula to calculate what you owe to a friend after you borrowed money and promised to pay a flat interest rate for it.
Compound interest, on the other hand, is when you pay interest on the principal and any accrued interest. If you start with a $100 balance on a loan with a 5% interest rate that compounds annually, you'll ultimately pay back $15.76 in interest due to the effect of compounding interest.
Interest can be compounded daily, monthly or annually. And as it compounds, more interest will accrue and increase the balance you owe.
Credit card issuers charge interest based on a daily interest rate, which is calculated based on your account's annual percentage rate (APR). You can find your daily interest rate by dividing your APR by 365 (the number of days in a year). The daily interest rate on a card with an APR of 17%, for example, would be about 0.00047%.
Compounding can be considered a blessing or a curse, depending on the type of account. For the same reason compound interest increases a credit card balance each day, it can also increase the balance of a retirement account you've invested in. In this way, the more frequently investment returns are compounded, the more you'll earn in interest yields.
Is Credit Card Interest Compounded Daily?
In most cases, credit card interest is compounded daily using a daily interest rate and an average daily balance.
Calculating the amount of interest you owe in a month can be complex. First, divide your credit card's APR by 365 to find your daily interest rate. Then find your average daily balance by adding any outstanding balance from the previous month to each day's balance for the ensuing month. You'll have to determine your total balance each day on your own by closely combing through your credit card statement. Divide the total by the number of days in the month.
Multiply your average daily balance by your daily interest rate.
In our example, let's say your average daily average credit card balance was $500 and your APR is 17%. Multiplying 500 by 0.00047% gives you 0.233. You'd then multiply that by the number of days in your statement period. For a 30-day period, 30 multiplied by 0.233 gives you $6.99. That's the amount of interest you'll owe for the month. You can use Experian's Credit Card Payoff Calculator to better understand how interest can affect your credit card balances.
It's important to note that for credit cards, APR and interest rate mean the same thing. That may not be true for installment loans like student loans and mortgages, though, since the APR will generally also take into account any origination or other fees charged by the lender.
How to Avoid Paying Credit Card Interest
It's possible to avoid paying credit card interest entirely. Even though interest accrues throughout the month, your credit card issuer will not charge you for it if you pay the whole statement balance by the due date.
Since most credit cards have grace periods, there's generally a 21-day period between the end of your billing cycle and your due date during which you won't be charged interest on an unpaid balance. As long as you pay your statement balance within that time period, you'll avoid paying interest charges.
You can also skip having to pay interest for a period of time if you use a credit card with a 0% introductory APR offer. Some cards offer an introductory APR period to new cardholders that lets you avoid interest on purchases and sometimes transferred balances for a period of months. Once the introductory period ends, the card's ongoing variable APR rate kicks in.
Or you may use a card that charges 0% APR on balance transfers for a set amount of time as a way to pay down a credit card balance without accruing interest. Balance transfer credit cards often come with balance transfer fees, usually 3% or 5% of the transferred balance, so make sure you understand any fees you'll be charged. You may find that the interest savings while paying off a balance are worth the fees you'll pay.
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Understanding the Impact of Credit Card Interest
While credit card interest compounds daily, that doesn't mean you're powerless to avoid the impact of these charges.
Make it a goal to pay off your statement balance each month, potentially by setting a budget that keeps your credit card spending in check. Or opt for a credit card that offers a promotional 0% APR for a stretch of time, and stay conscientious about paying off any charges or transferred balances within the promotional period. Interest can add up fast, but knowledge and planning can help minimize its effect on your budget.