How is Credit Card Interest Rate Calculated?

In an ideal world, you would pay your credit card bill on time every month and forever relish never paying any interest. But who are we kidding? Life is not always sunshine and rainbows, and one day, you will miss a payment for one reason or another. 

The reason could even be as simple as forgetting to submit the payment. But it is okay. That’s life! 

The credit card issuer will start charging interest on the uncleared balance if it is not cleared by the due date. This is the price you pay for borrowing money if you do not clear the bill before the start of the next billing cycle. 

Suffice it to say — understanding how your issuer calculates the interest rate can help you understand the cost of your debt and therefore help you plan better. Hence, this article gives you insights into the world of credit card interest. 

How Does Credit Card Interest Work?

Credit card issuers charge you interest only if you carry a balance from one billing period to the next. If you pay off your balance in full every month, no interest is charged on your spending. 

This is why one of the most significant credit card advantages is the interest-free period - usually between 30-55 days in Kenya, depending on the issuer.

Learn more: What is a Credit Card’s interest-free period? And How Does it Work?

If you have a balance at the start of a new billing period, when you purchase using your credit card, the balance increases; it decreases when you make a payment.

It is also essential to keep in mind the fact that if you use the credit card cash advance service (using your card to withdraw cash from an ATM), that amount will typically start accruing interest immediately as opposed to normal credit card usage that will give you an interest-free period. 

In most cases, the interest rate on a cash advance tends to be higher than the normal ‘purchases’ rate. That is why it is always advisable not to use your credit card to withdraw hard cash from an ATM unless it is an emergency. 

You can visit our credit card comparisons page to compare different issuers' rates. 

How to Calculate Credit Card Interest

The credit card interest rate is charged by the day, not by the month. That means if you do not clear your balance monthly and carry a balance, the issuer will apply a daily interest charge on the outstanding balance.

So, here is a three-step guide on how to calculate your credit card interest charge. 

1. Determine your average daily card balance. 

Most issuers use the compound interest formula. This means that interest is added to your original balance at the end of every day, which becomes the amount charged interest on the following day. 

So your average daily balance will be the initial outstanding balance + interest charged to date. 

Confirm with your issuer if you are unsure how they calculate your daily balance. Also, check your agreement (or statement) to confirm which days are included in the billing period - some issuers may exclude holidays and weekends. Your interest charge depends on your balance on each of those days.

Learn more: 10 Questions You Should Ask Your Credit Card Issuer.

2. Convert your monthly rate to a daily rate. 

After you determine your average daily balance, you need to figure out the daily interest rate per your issuer. Issuers will typically display monthly interest rates, which is a figure arrived at from the daily interest rate.

What is important, however, is that since the interest is charged daily, if you pay earlier within the same month, then you will be paying less than if you waited until the end of the month.  

The daily interest rate is simply the monthly interest rate divided by the number of days in the billing period. For example, if your card charges a monthly rate of 1.50% per month and the billing period is 30 days, the daily rate will be 1.50%/30. 

3. Calculate your interest charges

Now armed with your daily rate and average daily balance, it is easy to estimate your monthly/period interest charge. Simply multiply the average daily balance by the daily rate. Then take the figure you get and multiply it by the number of days in the billing period. 

Note: Keep in mind that some issuers offer a promotional period with either a zero-percent or low-interest rate. 

How Do Card Issuers Determine Interest Rates?

Some issuers use a single rate across the board. However, others charge different interest rates based on creditworthiness - ranging between 0.9% to 3.50% per month: the better your creditworthiness, the better the rates. Also, the type of credit card you take can influence the rates you get. 

Some issuers may also different rates for different types of transactions. For example, purchases and cash advances are charged different interest rates. 

How to Avoid Credit Card Interest Charges

The surest way to avoid paying interest on your card is to pay the balance before the due date. However, this is not always possible. 

But with the knowledge of how interest rates are calculated, it is easy to deduce how to keep your interest charges low. You now have control over some of the factors that determine your credit card's interest rate. 

For instance, paying more than the minimum payment as often as you can help keep your interest charge low. Every extra payment reduces your average daily balance, which in return will reduce the interest charged. 

So, in summary, you can reduce your credit card interest rate by:

• Paying off the balance in full (if possible)
• Paying more than the minimum amount every month
• Paying as often as possible. 

Who Determines the Credit Card Interest Rates?

Typically, the Central Bank of Kenya issues a benchmark rate, and the issuer sets their average rates in tandem to this benchmark. This benchmark applies to many different types of loans, including personal loans, business loans, etc. 

The benchmark rate is not static and fluctuates depending on the current market situation.

Learn more: ABCs of Credit Cards: What to Know About Credit Cards in Kenya

WRAPPING UP

Understanding how your credit card interest rate works and how it is calculated can help you avoid getting stuck in debt, consequently allowing you to stay on top of your finances. 

It is ideal to pay the bill in full and on time. However, if this is not possible, understanding how the interest rates are applied to your revolving balance might be a great start to help you plan better.