Credit card is one of the most profit making product for the financial institutions but at the same time the risks associated is extremely high because of default threat. This is the reason a very high interest is charged by the car issuers. Interest in addition to other fees is what makes big profit for the card issuers.

But do you know how financial institutions determine the amount of interest to be charged.

Consider following example:

Annual interest rate on credit card: 20%
Limit on the card: $5,000

As soon as a partial or late payment is made, interest begins to accrue on the full amount of the account.

A person wants to buy a refrigerator that costs $1000 but does not currently have the money for this purchase. So the person decides to use a credit card to buy the device.

A few weeks later, card bill is generated by the issuer. The account balance is now $1,000 which needs to be paid in two weeks. Unfortunately, the person has less than $500 and only makes a partial payment of $500.

Here are the important dates for the interest calculation:

• 1 January, 2018 – Purchase of refrigerator
• 15 January, 2018 –  Card statement generated due on 31 January
• 20 January, 2018 – $500 payment on credit card
• 15 February, 2018 – New card statement showing the remaining balance of $500 + interest for not having paid the amount in full

Daily Interest Rate

First, the daily interest rate for this credit card is calculated because this percentage will be used as the basis for our calculations. The annual interest rate is simply used to calculate the daily rate.

Here’s how to calculate the daily rate:

Annual interest rate 20% / 365 days in a year = 0.0548%

Partial Payment – Interest Calculation

Under the previous scenario, what would be the amount of interest charged on the February 15 statement?

When an amount remains unpaid on a credit card, interest is charged from the initial purchase and on each subsequent purchase until the card is paid in full. To stop the interest on the credit card, it is necessary to make two full payments in a row.

On January 1st, the credit card balance becomes $1000 following the purchase of the refrigerator. As soon as the person receives the statement of account, full $1,000 must be paid to avoid paying interest. However, on January 20, 2018, card user pays only $500. On the next statement, the balance will be made up of the balance of the $500 that had not been repaid and an amount of interest added.

The interest will be calculated from the date of the original purchase as follows:

Interest for a period = Amount of credit card debt x daily rate x number of days

We have to do this equation twice to find the interest on the account statement, on February 15, 2018:

From January 1, 2018 to January 20, 2018 (payment date): $1,000 x 0.0548% x 19 days = $10.41

This $10.41 amount of interest runs for the period beginning with the purchase of your refrigerator, and ends with the first payment of $500.

Now it is necessary to calculate the interest for the period beginning on the payment date and ending on the date the next statement is generated:

500$ balance outstanding x 0.0548% x 26 days (difference in days between the payment date January 20 and the statement date February 15) = $7.12

On the account statement, the amount will therefore be $500, i.e. the amount still to be paid + $10.41 (interest from January 1 to January 20) + $7.12 (interest from January 20 to February 15) = $517.53

Thereafter, if the person makes a payment of $517.53 on February 28, will his balance be zero?

Unfortunately not, because even if card user has paid the full amount, there will still be interest to be paid between the date the statement is generated and the date of payment.

The balance as on February 15 was $517.53 and interest continues to accrue until full payment is made on February 28:

517.53 x 0.0548% (daily interest rate) x 13 days (number of days between statement date and payment date February 28) = $3.69

This shows that even if you pay the full amount of the February 15, 2018 statement ($517.53), the next statement will show a balance payable of $3.69. By paying the last amount, the balance will finally reach zero.

This was an example with only one purchase, but in a real world there will be several purchases on a credit card. Interest is almost impossible to calculate manually. The interest generated by each purchase should be calculated until the credit card is paid in full.

It is also important to remember that if a person makes a late payment or partial payment, the interest payable will begin on the day of the initial purchase.

Late Payment – Interest Calculation

The calculation concept for a late payment is very similar to a partial payment. Let us go back to the example at the beginning:

1 January 2018 – Purchase of refrigerator
15 January 2018 – Receipt of the invoice, which is due on 31 January
12 February, 2018 – Late payment of $1,000
15 February 2018 – New account statement generated showing the balance of interest incurred

The full payment was therefore made 12 days late. Penalty will not be charged for the 12 days of delay, but from the date of purchase:

1000$ purchase refrigerator x 0.0548% daily rate x 42 days (number of days between the date of purchase January 1st and the date of payment February 12th) = $22.76

The statement of account printed on February 15 will indicate a balance payable of $22.76. After this full payment, the card balance will be nil.

Conclusion

The only way to avoid fees is to always pay the amount due in full before the deadline indicated on the account statement. Failure to make a full payment before the maximum date will result in interest being charged.