Understanding the cost of interest

child with adding machine

When it comes to finance, interest makes the world go ‘round. Interest is the incentive that motivates financial institutions to lend consumers money, and compels those same consumers to put their money into savings accounts and other savings vehicles (where that money is ultimately loaned back out to other consumers).

Consumers experience interest in a variety of ways, most commonly through credit cards, loans (home and auto), and savings accounts. How that interest is calculated and what it costs can vary pretty dramatically, but the core concepts are generally the same across the board. To keep things (somewhat) simple, let’s focus on the interest charged on credit card purchases.

How your rate is determined

Like everything else where credit is concerned, the interest rate a creditor is willing to offer you is based on your potential riskiness as a borrower. If you’ve used credit wisely in the past (made timely payments, stayed below your limits, avoided defaulting on accounts), the risk in lending you money is relatively low, and you will likely receive a lower interest rate as a result.

Conversely, if your credit history is a bit more checkered (missed payments, too many recently opened accounts, a bankruptcy within the past 7 to 10 years), you can expect a higher interest rate. While there is technically no limit on how high these rates can go, they typically range from 10 percent (good) to 29.99 percent (not so good).

How interest is calculated

APR stands for Annual Percentage Rate and it’s how the vast majority of credit card and loan rates are expressed. In its simplest interpretation, APR indicates how much interest will accrue after one year. A $1,000 debt with an APR of 25 percent will (hypothetically) accrue $250 in interest charges in one year. Except it doesn’t quite work like that.

This is because interest isn’t calculated once a year – it’s usually calculated every single day. A more accurate number, therefore, is your daily periodic rate. This is essentially your annual percentage rate (25 percent) divided by the 365 days of the year (in this case, 0.068 percent). Note: to make matters more complicated, your lender may use 360 instead of 365. Always be sure to read your lending agreement (exciting, I know) to understand how interest is calculated on your account.

So interest is accruing every day. Recognizing that account balances shift as more purchases occur and payments are made, lenders usually take things one step further and charge interest based on your average daily balance. If your balance was $10 for 29 days and then shot up to $800 on day 30, your average daily balance would be $36.33 ($10 x 29 days plus $800 x 1 day divided by 30 days equals $36.33 per day). Multiply that ($36.33) by your daily periodic rate (0.068 percent), then multiply that by the number of days in the billing cycle (30) and you have your interest charge ($0.74).

When interest begins to accrue

Interest on new purchases begins to accrue immediately (see above about average daily balances) unless you’ve been paying your balance in full every month. This is because almost all credit cards include something called a grace period.

Here’s how that works: Your card has a zero balance. You make a purchase. If you pay back the borrowed principle before your next due date, no interest will be charged. If you carry a balance past that due date, however, the grace period ends, and any new purchases or charges will begin to immediately accrue interest.

This is very important to keep in mind, especially if you’re about to attempt to pay off an account. If you’re not presently in a grace period, interest is accruing every single day. So if you receive a statement and the balance shows as $800, depending on when you make your payment, $800 may not be enough to pay the balance in full. In other words, the balance was $800 on the day the billing period ended, but if any time has passed then interest has accrued and will be added to the balance at the end of the month. This is typically called trailing interest.

Whenever you pay off an account, be sure to contact the creditor directly to get an accurate payoff amount. You should also be sure to check your next statement to make sure that it reflects a zero balance.

Always know what you’re signing up for

Interest can be a little complex, but understanding how it works can make a huge difference in how you approach and manage money. Make sure you understand the terms and conditions of any loan, credit card, or bank account before signing an agreement. That might require reading a little fine print, but if the effort can save you some money, it’s worth it. Good luck!

Tagged in Debt strategies

Jesse Campbell is the Content Manager at MMI. All typos are a stylistic choice, honest.