Many who owe credit card companies balance on their bill do not even know how the interest on that balance is calculated – they pay it without asking a question, and they are always skeptical about the amount of interest charged (in other words, they think they are being robbed by their credit card company).

Since the issue of credit card interest is a common issue that affects a very large population in North America, I have decided to write a quick guide explaining how credit card companies charge interest…

Let’s start by assuming the following:

• You have a balance of $0 on your credit card.
• Your credit card company charges you 20% yearly interest on purchases.
• You are only making purchases (and not using the cash advance functionality – this assumption is made because cash advances usually have a different [higher] interest rate than that of purchases, and there are fees associated with cash advances)
• Your credit card company charges you interest on the 20th of every month.

Now, on the month of March, you made the following purchases:

• $1,000 in an airport on March 10th.
• $200 in a grocery store on March 18th.

Your invoice gets issued on April 20th, instructing you to pay at least the minimum payment (usually $10) by May 10th. The invoice amounts to $1,200. You make a payment of $200 before that date – so, while you did make the minimum payment, you will be charged interest because you haven’t paid your invoice in full.

Now, on the month of April, you make the following purchases:

• $1,000 buying a laptop online on April 10th.
• $200 on clothes on April 18th.

On May 20th, you login to your bank account, and you are surprised to see that your credit card invoice was $2,238.90 and that the interest charged is $38.90. Huh? You start wondering, how did they calculate the interest? Well, here’s how:

The $200 payment made back on April goes to your last credit card purchase (most banks follow the LIFO [Last In First Out] system for payments), which means that you haven’t paid anything from that $1,000 purchase at the airport. Now, all credit card companies charge interest from the day that the purchase was made in case the balance wasn’t paid in full, which means interest has been accruing on that $1,000 airport purchase from March 10th until May 20th (a total of 71 days), which means that the interest on that purchase will be the following: $1,000 x 71/365 x 20% = $38.90.

Now, after being relieved that the bank didn’t rob you, you make a payment of $238.90 to the bank, which lowers your balance to $2,000. On the month of May, you make just one purchase of $1,000 (an expensive gift for the wife – which is something that you shouldn’t do if you’re not able to pay your bill in full, but I’m not judging here).

on June 20th, you login to your bank account again, and you see that your invoice is $3,055.88. Here’s why…

$38.90 from the $238.90 that you have paid on the month of May when to settle the interest (which was $38.90), and $200 went to settle the last purchase for that cycle (which was the $200 purchase of clothes). This takes back the total to $2,200, but – since you haven’t paid for that laptop you have purchased on April 10th, you are charged interest for 71 days (from April 10th until June 20th), totaling $38.90. Additionally, you will be charged interest for the $1,000 purchase you have made on the airport, but this time from the last time you were charged interest (e.g. from May 20th) and not from the date of purchase, which means that the $1,000 will be charged interest for 31 days, or $16.98. The sum will be $1,000 (airport purchase on March) + $1,000 (laptop purchase on April) + $1,000 (Gift for the wife on May) + $38.90 + $16.98 = $2,055.88.

Now that things are very clear for you, make your payments on time and try to lower your balance every month by not buying things that you don’t need, because if you buy things you don’t need you’ll soon sell things you need (that’s Warrent Buffet who said that).

Hope the above tutorial helped!

This article (as well as all other articles on this website) is an intellectual property and copyright of Fadi El-Eter and can only appear on fadi.el-eter.com.