One of the easy and smart ways of shopping is by using your credit card. The reason is, it provides you with the facility of buying even if you don’t have enough money and you can pay for it later. It also offers you credit points that can provide you with discounts and other attractive offers. But do you know that interest is also charged by the credit card company over the billing amount? And do you know what method they use to calculate this interest?
As a credit card user, you should know that. We do focus on the billing amount, due date, terms of the billing cycle, minimum balance, annual charges, and the grace period, but we often neglect to see the interest rate on credit card.
We have made this simple guide that will make it easy for you to understand the interest calculation method by the companies.
Average Daily Balance Method
Most of the companies in India use the Average Daily Balance Method to calculate the interest amount. In this method, the daily balance of the credit card is considered. If you purchase something else, that amount is also added from that day and onwards.
Let’s calculate the method with an example. Let’s say there is a person, Mr. Ravi, who purchased something with his credit card and his billing cycle is of 30 days. Assume there is an annual interest of 24% levied on the billing amount. Now let’s say his billing cycle starts with Rs. 25,000 balance. On the 10th day of the month, he purchased goods worth Rs.8,000 and on the 20th day he paid Rs. 10,000 to his credit card’s billing cycle.
Now the calculation of the interest will go in this way:
- We have to calculate the average balance for the 30 days period.
From 1st to 9th day, the balance will be Rs. 10,000. So this balance will be added for the 9 days straight.
Rs. 10,000 x 9 days = Rs. 90,000.
- From 10th to 19th day, the balance of billing cycle will be Rs. 10,000 + Rs. 5,000 = Rs. 15,000.
In these 10 days, the added balance will be equal to Rs. 15,000 x 10 days = Rs. 1,50,000.
- Now from the 20th to the 30th day, the balance will be Rs. 15,000 – Rs. 7,000 = Rs. 8,000.
The total balance for these 10 days will be Rs. 8,000 x 10 days = Rs. 88,000.
- Now we will calculate the total average balance
(Rs. 90,000 + Rs. 1,50,000 + Rs. 88,000)/30 = Rs. 10,933.
- Divide the billing cycle days by the total number of days in a year.
30/365 = 0.0821
- Now multiply 0.0821 with the annual interest rate on credit card.
0.0821 x 0.24 = 0.197
- In the final step, we will multiply the number with the daily average balance to find the payable interest.
0.197 x Rs. 10,933 = Rs. 2,154
Rs. 2,154 is the amount that Mr. Ravi has to pay as interest.
- There is also a formula to calculate the interest amount = (Days in billing cycle x Annual percentage rate x Average daily balance)/365
While using the Average Daily Balance method, some of the banks also add charges made during the month. This increases the daily balance, which ultimately increases the interest amount. So remember to check in which way your bank is calculating the interest.
When do you have to pay interest on a credit card?
Credit card providing banks and companies only charge you the interest when you don’t make the payment in full. The bank charges the interest over the partial payments, the minimum amount to be paid, or the amount lesser than the minimum amount. Many credit card companies also provide you a grace period so that you can bill a little late according to your circumstances, but once the grace period is over, they will charge you interest over the amount. Note that the banks apply the Monthly payment Rate (MPR) and not the Annual Percentage Rate (APR) to calculate the interest.
A credit card is a good tool to purchase things you need even if you don’t have any money. It also gives you the benefit of earning rewards points that can give you discounts and other exciting offers. But the credit card also comes with the responsibility of paying bills on time. If you are not paying your bills in full before the due date, the banks are liable to charge interest over the bill amount. This makes it important for you to know the method that banks use to calculate how much interest a credit card user has to pay to them.