How is credit card interest calculated?

Clearing your credit card balance by the due date each month ensures you won't incur any interest charges.

However, if you can only repay a part of the balance, the lender will apply interest charges. So it's useful to understand how they calculate those charges.

What is an APR?

An APR (annual percentage rate) is a set of agreed rules that all credit card providers follow when calculating interest rates. It allows you to compare interest rates charged by different providers in a fair and standardised way.

The APR is based on the interest rate applied for standard purchases. You may find that a particular credit card has different interest rates for purchases and balance transfers. However, it is the standard purchase rate that all card providers must use for their APR.

An APR is usually based on a credit limit of £1,200. It also assumes you spend the full £1,200 on day one, make equal monthly repayments over the year, and do not spend anything else on the card.

Providers offer a representative APR (the rate they display on their website and in advertisements) to at least 51% of individuals. However, they might offer you a rate based on your credit history, known as your personal APR.

How do credit cards calculate interest?

Your credit card provider will do the sums for you and send you a bill every month. If you want to double-check their calculations, this is how to do it:

• Convert your personal APR to a daily rate by dividing the APR by 365.

For example, if your APR is 18%, divide 0.18 by 365 which equals 0.00049315. If your APR is 22%, divide 0.22 by 365. (Please note some credit card providers may use 360 instead of 365 but it doesn’t make a significant difference.)

• Next, work out your average daily balance.

To do this you’ll need to take your balance on day one of the billing period. Then add that to the balance on day two, day three, and so on until you reach the end of the billing period. Divide this by the number of days in the billing period to get the average daily balance.

For example, if your billing period is 30 days, you should have 30 numbers to add up i.e. the balance on each day of the month and divide that number by 30. For example, a total of £207,000 divided by 30 = an average daily balance of £6,900.

• Next, multiply your daily rate by your average daily balance to get your daily interest amount.

i.e. 0.00049315 x £6,900 = 3.402735

• And then multiply that daily interest amount by the number of days in your billing cycle (usually around 30 days) to calculate the amount you owe that billing cycle.

3.402735 x 30 = £102.08

The total shows roughly how much interest you'll have to pay for that period.

There are two reasons why this might not be exactly the same as the amount that appears on your statement:

The first is because most credit card providers give you 56 interest-free days on new purchases. This means you don’t have to worry about any interest occurring during that time. Obviously, not all spending happens on day one of the month. For accurate interest calculation, you must identify the day of each purchase. And then add 56 days to establish when you need to start paying interest on it.

The second matter is whether the credit card provider adds interest on a daily or monthly basis.

If they apply the interest at the end of the month, the total mentioned earlier will be reasonably accurate. However, if the credit card provider compounds interest (as many do), they will add interest at the end of each day (not month).

So you are not only paying interest on the balance each day but also on the previous day’s interest. This mounts up very quickly.

Calculating the interest you owe based on the exact timing of purchases and compound interest is time-consuming. Over one month it doesn't make too much difference. You’ll get a good idea of the interest you owe by doing the above calculations.

It's important that you understand how interest rates work. But, if possible, the best course of action is to pay off your balance and avoid paying interest altogether.