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Financial Literacy

Financial Literacy

Home Finance Credit and Debit Calculating Interest

Calculating Interest

You have a credit card with an interest rate of 18%. Seems pretty straightforward: 18% is 18%, right?


Unless you’ve been sleeping with your eyes open in every Trig, Calculus, and Statistics class you’ve ever taken, you probably know that numbers love to be moved this way and that. Move a decimal point here, tally up things a little differently there, and you’ve got a whole new set of numbers. To watch this in action, just check out the fancy financial footwork politicians get up to when it’s budget time in an election year.

Just like your friendly politician, credit card companies can get pretty creative when it’s time to add up what you owe them. There are a few different ways to tally up the interest you owe, and a lot of that depends on when they tack on that 18% interest:

Adjusted Balance

This one’s a breeze to figure out:

  1. Find the beginning balance by carrying over last month’s ending balance.
  2. Add any bodacious buys you’ve made this past month.
  3. Subtract any payments you’ve made.
  4. Ta-da! The final number is Adjusted Balance. The card company can then calculate interest on this balance.

Easy peasy, lemon squeezy. Credit card companies tend to shy away from this basic method because your payments are taken off before interest is added. That means they’re charging you interest on a smaller balance and getting less money from you.

Previous Balance

Here’s another idea: use the balance at the end of the past month and charge interest on that.

Credit card companies like this idea because they’re charging interest on your balance before you make your payments (so they’re charging 18% on a larger number).

Average Daily Balance

This one is about taking all the charges and purchases you’ve made over the month and tallying up a weighted average daily balance.

Let’s say Gnarly Gary has a credit card balance of $3,000 from last month. He makes it through the 26th of this month without using plastic and then charges $1000 for a new surfboard he had to have. How will his card company decide how to charge interest?

Let’s take a look:

Gnarly Gary’s plastic went 25 days with a $3,000 balance. Then it had 5 days with a balance of $4,000. To tally up the daily average you would multiply the number of days by the amount and divide by the number of billing days. So…

25 days x $3000 = $75,000
5 days x $4000 = $20,000
$20,000 + $75,000 = $95,000
$95,000 divided by 30 days in the billing cycle = $3166.67 per day.

So if Gnarly Gary has a credit card interest rate of 18%, his interest is 1.5% a month (0.18 divided by 12 months is .015) so his minimum payment is at least $47.50…assuming he wasn’t a Shmoop reader and didn’t know he should never pay just the minimum on his credit card.

Calculating daily weighted interest is how most credit card companies do things. It’s also the method you’ll want to avoid the most. Why? It means you end up paying interest on interest—and that’ll add up quick. It pays to hunt around for a card that tallies up interest on your adjusted balance. And there you have it. That's how credit card companies make sure that 18% isn’t always 18% and why your BFs minimum monthly payment is different than yours even if you have the same interest rate.

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