Common Interest Calculation Methods

People have used credit cards for years to make purchases, but few realize how interest calculation comes in to play. If you aren't sure how your interest is being calculated, you may be paying more in interest than you think. It is important to read all of the "tiny details" on your credit card statement so that you know how your finance charges are being calculated. If you find that you are paying more in interest than you believed, you may want to transfer your balance to another company.

Here are the most common methods used to calculate interest on credit card balances:

Average daily balance

The most common calculation method used for calculating your interest is the Average Daily Balance method. With this method, your credit card company uses the total number of days in the billing cycle, adding up how much you owed at the end of every day in that cycle. Once the sum is determined, it is divided by the total number of days in the cycle.

So, if you had an approximate balance of $600/day for the first 14 days, then made a purchase and had a balance of $700/day for the last 17 days, the formula would be: $600 x 14 + $700 x 17/31 days = $650.66. This is your average daily balance. You would then multiply this figure by your annual percentage rate and divide by 12.

Adjusted balance interest calculation

If you must pay interest, this method is most in your favor since it results in lower interest charges.

Basically, all payments made since the previous billing balance are subtracted, and new expenditures are not factored in to the equation. Interest rates are applied to the lowest possible balance, since new purchases are not added in to the balance and all payments are deducted. This means that you have the lowest possible balance when interest is applied.

Previous balance interest calculations falls between average daily and adjusted balances

This method of calculating interest falls between the previous two methods. While it is not as favorable as the adjusted balance formula in regards to interest, it does mean less interest than the average daily balance method.

With the previous balance method, interest applies only to the outstanding balance on your account at the end of the previous billing cycle. If you have made purchases in the current month, those are not included in the outstanding balance. Payments you have made are not deducted using this method, so the amount of interest you will pay will be higher than with the adjusted balance method.

If you make purchases with credit cards, the smartest thing to do is to pay off the entire balance within the grace period so that you incur no interest charges.