How to Calculate and Reduce Credit Card Interest Charges

Credit card debt can be a real nightmare. Currently, the average credit card debt per household is $14,750, while 610 million credit cards are owned by U.S. consumers, which means that each American has 2 credit cards since birth. No doubt then why credit card debt accumulates so fast and the number of Americans carrying credit card debt is growing over the last years. According to the US Census Bureau, the U.S. credit card debt in 2010 reached $886 billion and it is expected to reach $1.177 trillion in 2011.

The biggest mistake that most credit card holders do is paying their minimum fee every month. Yet, this covers only the interest and a minor fraction of the principal, which explains why credit card debt takes forever to be paid off, while you spend thousands on finance charges. Here is how you can calculate the interest charged on your credit card and, consequently, reduce it by making more than the minimum payment.

Calculating the Average Daily Balance

Most credit card companies calculate the average daily balance to charge interest on your credit card. The finance charges are typically calculated using the annual percentage rate (APR) that can range between 0% and 20%, or even exceed 20% if you have a bad credit record. The average daily balance method adds the daily balances in your card for a particular period of time and divides the sum by the total number of days in that period.

Here are the steps to calculate the interest charged on your credit card by using the average daily balance method:

Assuming that your credit card balance is $11,000 with APR 17.64% and fixed monthly payments $214.56, you are expected to pay off your credit card debt in 96 months.

On day 1 you make a purchase of $51.42. On day 4, you make a payment of $214.56. On day 8 you make a purchase of $102.18. On day 11, you make a purchase of $28.54. On day 15 you make a payment of $214.56. On day 19 you make a purchase of $18.15. On day 22, you make a payment of $350.

To calculate the total daily balance, you calculate the daily balance of each day and then sum up all balances.

Day 1 - 3: $11,051.42 (purchase of $51.42)

Day 4 - 7: $10,836.86 (payment of $214.56)

Day 8 - 10: $10,939.04 (purchase of $102.18)

Day 11 - 14: $10,967.58 (purchase of $28.54)

Day 15 - 18: $10,753.02 (payment of $214.56)

Day 19 - 21: $10,771.17 (purchase of $18.15)

Day 22 - 30: $10,421.17 (payment of $350)

Adding up all daily balances:

(3 x $11,051.42) + (4 x $10,836.86) + (3 x $10,939.04) + (4 x $10,967.58) + (4 x $10,753.02) + (3 x $10,771.17) + (9 x $10,421.17) = $322,305 total daily balance.

Dividing $322,305 by 30 days, you get $10,744 average daily balance.

Since your APR is 17.64% it means that you are charged 17.64%/12 = 0.0147 monthly.

Multiplying the average daily balance $10,744 by 0.0147, you get that your monthly finance charges are $158. So, more than half of your payment is actually interest charges.

What are you going to do about this?

Making Higher Payments

To understand how minimum payments affect your total balance, assume that, instead of making two minimum payments of $214.56 on days 4 and 15 and one extra payment of $350 on day 22, you make fixed payments of $300 every month.

By paying $214.56 you are actually paying only 1.95% of your debt. This means that the total interest you will pay on your debt will be $29,099, or 2.6x your current balance.

By making fixed payments of $300, you are actually paying only 2.7% of your debt. It may not make too much difference as a percentage of debt, but total finance charges will be $4,573.96, which is 0.5x your current balance. Evidently, it will take you longer to pay off your debt by paying making minimum payments. On the condition that you do not accumulate extra debt on your credit card, your balance will be getting lower, thus lowering interest charges as well.

Sources:

http://www.creditcards.com/credit-card-news/credit-card-industry-facts-personal-debt-statistics-1276.php

http://www.hoffmanbrinker.com/credit-card-debt-statistics.html

http://www.investorwords.com/350/average_daily_balance.html

http://www.bankrate.com/free-content/credit-cards/calculators/free-credit-card-payoff-calculator/

http://cgi.money.cnn.com/tools/debtplanner/debtplanner.jsp

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