How your interest is worked out
The underlying calculation method
When your card company calculates the interest you owe it uses either the “average daily balance method” or the “daily balance method”. Although the two methods differ in their way of calculating interest they generally result in the same interest charge.
Average daily balance method
The average daily balance on your credit card is the balance you carried during your statement period, averaged by the number of days in the statement period (usually 30 or 31). It is calculated at the end of the month by adding the balance at the end of each day, then dividing the total by the number of days in the billing period.
To calculate the interest charged for the month you multiply the average daily balance by the daily interest rate (obtained by taking the annual interest rate and dividing by the number of days in the year), then multiply the result by the number of days in the billing period.
Daily balance method
Where the average daily balance method only makes a month-end calculation of the interest owed, the daily balance method calculates interest owed at the end of each day of the billing period.
To calculate the daily interest charge you multiply the daily balance by the daily interest rate (obtained by taking the annual interest rate and dividing by the number of days in the year). Then add up the resulting daily interest charges to obtain the amount of interest charged for the month.
The following examples show how the two methods work.
Mr X receives a new credit card on 1 March. On 5 March he makes a purchase of £3,000. His March statement, which covers the period between 1 March and 31 March (a 31 day billing period), has a payment due date of 19 April.
Let’s assume that:
- Mr X didn’t pay his bill in full, by the due date, meaning that the interest-free period doesn’t apply to his purchase (an explanation can be found in the section on when the interest-free period applies)
- Interest is charged from the purchase date of 5 March
- Mr X didn’t buy anything on his credit card during April. When his April statement arrives it shows an interest charge of approximately £41.00, based on an annual interest rate of 18.5%. If we divide 18.5% by 365 we arrive at a daily interest rate of 0.05068%.
In cases where you are making lots of transactions and payments, this calculation can quickly become quite complex.
The length of the interest free period
You usually benefit from an interest-free period when you buy something with your credit card, as the card company doesn’t start charging you interest on your purchases right away. In other words, you are getting credit without having to pay for it, making credit cards very cost-effective. However, unless you pay in full every month the interest-free period doesn’t always apply to new purchases.
The interest-free period has two parts:
- The time between the purchase and your statement date
- The time between your statement date and your payment due date.
The maximum length of the interest free period is shown in the Summary Box, and only applies if certain conditions are met.
Interest is normally charged immediately on transactions such as cash advances, credit card cheques or balance transfers. This is because you are effectively borrowing cash, from the moment it is withdrawn or the balance is transferred.
- Mr X’s statement covers transactions he made between 1 May and 31 May
- Mr X made a new purchase on 5 May
- Mr X’s payment due date is 19 June
- Mr X pays the full balance by 19 June.
Whether the interest-free period applies to all purchases
Credit card companies tend to use one of two methods to decide whether the interest-free period applies to your new purchases.
- Method A: The interest-free period applies to your new purchases only if you pay your current month’s balance in full, by the due date.
- Method B: The interest-free period applies to your new purchases only if you pay your current month’s balance in full, by the due date AND you have also paid your previous month’s balance in full, by the due date (in other words, you are not carrying a balance from the previous month).
Let’s assume that Mr X didn’t pay his April balance in full, so he carried a balance of £2,000 from that month.
On 5 May he made a new purchases of £1,000. He paid his new balance of £3,000 (£2,000 + £1,000) in full, by the due date shown on his statement of 19 June.
Here’s how the two methods would affect him:
- Method A: Mr X would have to pay interest only on the £2,000 carried over from April. He will get the interest-free period on his new purchase of £1,000 because he paid his current balance in full by the due date of 19 June.
- Method B: Mr X would have to pay interest on the £2,000 carried over from April and on the new purchase of £1,000 (i.e. the full £3,000), because he carried a balance over from April.
The rules on when the interest-free period applies are shown in the Summary Box.
When the interest calculation starts
Different credit card companies will calculate interest on a transaction from different points in time, either the transaction date or the posting date.
- The transaction date is the date of the purchase or cash withdrawal. For example, if you bought a CD player on 1 March then 1 March is the transaction date.
- The posting date is the date that a transaction reaches your account. A shop may collect credit card transactions over a period (of several days) and then process them all at once, so there may be a delay before the transaction reaches your account.
Most UK credit card companies charge interest from the transaction date. There is a slight advantage to you if your credit card company charges from the posting date as it means the transaction reaches your account later, but this is likely to affect only a very small number of the transactions you make.
Detail on when the interest calculation starts are shown in the Summary Box.
When interest charging stops
When you repay your balance in full different credit card companies will stop charging interest on the amount being repaid at different points in the charging cycle. This may coincide with either the transaction date of your payment or the posting date, when funds are cleared or when payment is made in full on the previous statement date.
- The payment transaction date is the date you made the payment at a bank or when the credit card company received your payment.
- The posting date is the date when your payment is credited to your account.
Funds are cleared when the card company is certain that your payment will not be returned for any reason.
The earliest date that the interest could stop, when a full payment is made, is the statement date preceding the payment.
There is an advantage to you. The earlier your credit card company stops charging you interest the less you will pay. Your card company provides you details on when the interest calculation stops in the Summary Box.
If you repay your outstanding balance in full, you may qualify for an interest-free period.
Whether residual interest is charged
If you pay-off your balance in full some credit card companies will still charge you interest on the amount borrowed during the month in which you make your payment, assuming you carried forward a balance from the previous month. This is known as residual interest. In other words, if you carried a balance over from April, have paid your May statement in full and make no further purchases during June, you may still see interest charged on your June statement for the outstanding balance between the date of your May statement and the date that your credit card company treats your repayment as being made (see section above on When the Interest Calculation Stops).
Your card issuer may choose to waive the residual interest.