It is important to know how credit card interest is calculated. It is not calculated the same way that a CD or an interest bearing savings account is calculated.  The key problem for the consumer is that the credit card interest rate is calculated daily.  I’ll will explain more in a minute on this.  First let’s go over the typical balance types that credit card companies use:

  • Average Daily Balance
    By far the favorite of credit cards.  Every day, your balance is recalculated with any payments, adjustments and/or additional finance charges.  With some credit cards, new purchases are also included in this calculation.  At the end of the month, these daily balances are averaged over the number of days in the billing cycle.
  • Two Billing Cycle Balance
    This method is most advantageous for the credit card company.  This method is an extension of the average daily balance method, but utilizes two billing cycles to come up with the average daily balance.  The typical grace period (which is usually 28 days) is non-existent under this method.  Also, all your payments, regardless of size, do not truly reflect in the interest calculation until two fulls months later.  Definitely shy away from this kind of offer.
  • Adjusted Balance
    If possible, this is the method you want to be using.  Under this method, all payments and credits are subtracted from the preceding billing period ending balance.  Therefore all interest calculations for the current month are being exacted on a lesser balance.

So when you are shopping credit card offers, take the above information into consideration.  It may not sound like it makes much of a difference, but you will see in a moment just how much of a difference it can make.  Remember above how I said that credit card interest is calculated daily?  This is how virtually all credit cards calculate interest.  This means that every day compounded interest is added to your balance.  But Jeffry, I don’t see it reflected in my balance, what are you talking about?

Well, the interest charges are not added to the balance until the end of the billing cycle, however they are accruing each and every day.  This is just another problem with utilizing credit card debt, and another reason why it is so incredibly hard to pay off those credit cards.  The following chart compares an annual interest bearing account with a credit card, to show the difference that daily compound interest makes.

The Difference Between Daily and Yearly Compound Interest

Yearly Interest Bearing Initial Balance $10,000.00
Daily Credit Card Initial Balance $10,000.00
Interest Rate 12%
Years Interest Bearing Balance Credit Card Balance
$10,000.00 $10,000.00
1 $11,200.00 $11,274.74
2 $12,544.00 $12,711.98
3 $14,049.28 $14,332.43
4 $15,735.19 $16,159.45
5 $17,623.42 $18,219.37
6 $19,738.23 $20,541.87
7 $22,106.81 $23,160.43
8 $24,759.63 $26,112.79
9 $27,730.79 $29,441.50
10 $31,058.48 $33,194.53

The spreadsheet above illustrates the difference that daily compound interest can make.  The interest bearing balance is also compounded, but only yearly and still there is a significant difference over time. Notice that the initial balance was the same in both instances, as well as the interest rate.  The chart of course, assumes no payments are being made in either case.  But as you can see, the way credit card interest is calculated does play an important factor.  So if you have credit card debt in addition to a car payment, house payment, etc. focus on paying down the credit cards first, as they almost always cost you the most money in the long run.  If you wish to download the spreadsheet to play with the numbers, you may do so here:

The Difference Between Daily and Yearly Compound Interest.xls

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