Why is your credit card bill so huge: how credit card interest is calculated and what grace period means

I personally don’t carry a credit card balance unless my credit card is offering a 0% APR promotion because one of my goals in the credit quest is to build a perfect credit history without paying a penny in interest. But from my observation, I’m not the norm. Many people I know carry balances from time to time, and when they come to me for advice, I always tell them to at least pay the minimum to avoid late payment fees, and over time I have helped them save quite a bit of money from that.

Honestly though, paying just the minimum amount is never going to pull you out of debt since credit card interest accumulates everyday at an absurdly high rate. There are many reasons to underestimate interest charges.

– Some people think that interest only accumulates from the end of a billing cycle, while in reality interest starts accumulating as soon as you make a purchase or take a cash advance.

– The interest is assessed not on the balance of the billing cycle, but on the average balance during the cycle.

– And grace period doesn’t apply if you carry a balance. So if you’re wondering why your credit card bill is so large, check these misconceptions if you made any of them.

If you don’t give a hoot about a technical demonstration of these three points, you can stop reading here. In case you’re a math geek like me, read on.

Let me explain to you how your credit card bill is calculated.

Every month, the credit card issuer sends you a monthly statement, either via mail or electronically, informing you of the outstanding balance. For a sample statement, you can visit: http://www.federalreserve.gov/creditcard/flash/readingyourbill.pdf

Provided at www.federalreserve.gov/creditcard/flash/readingyourbill.pdf‎
Sample from the Fed. See if you can spot the current balance and interest charge.

The interest in the next billing cycle will be based partially on the outstanding balance. Let’s make this our starting point, day 0, and let’s assume that the outstanding balance is $1,035. And let’s say the minimum amount of $35 is due on day 21. To simplify, let’s say you pay the minimum amount right away on day 0, so the balance you’ll start the next billing cycle with is $1,000.

If you carry this balance through the next billing cycle, and assuming each billing cycle has 30 days, your interest at the end of the billing cycle, day 30, will be: $1,000*Daily interest rate*30
Assuming the daily interest rate is 0.05% (which translates to an APR of 18%), the interest for the month will be $1,000*0.05%*30=$15.

Doesn’t look too bad to you? If you keep going at that rate hypothetically, you’ll pay $180 for the year. 180 dollars. On a balance of $1,000. Does this change your perspective?

Now you’ll probably make some purchases on the card during the billing cycle, so let’s add another layer of complexity. Let’s assume that you make one purchase of $1000 on day 15 during the billing cycle. The daily interest rate won’t change, but the balance used to calculate interest will not be $1,000 anymore. Most banks use a method called average daily balance to determine said balance.

Each day in the billing cycle, they record the balance at the end of the day. Then they add up those balances and divide by the number of days in the billing cycle, 30. So in our scenario, your balance is $1,000 for the first 15 days, and $2,000 for the next 15 days. The average daily balance is $1,500. The interest at the end of the billing cycle is $22.5. Your total bill will be $1,500+$22.5=$1,522.5

CC interest graph 1

In the first example I assumed the beginning balance for the billing cycle was $1,000. In the second example, I am going to assume that we start the billing cycle with $0, but charge $1,000 immediately. What difference does it make, you wonder? You still have the $1,000 piece and the $500 piece at the same timing as before after all!

Well, there is a twist to the way interest charge is determined if you start the billing cycle with $0 balance, that is, if your credit card issuer offers something called “grace period”.

Grace period is the amount of time after the monthly statement date in which if you pay off the entire reported balance you will not be charged interest for the entire preceding billing cycle.

Using the same numbers, as we calculated before, the amount of interest accumulated by the end of day 30 is still $22.50. But that doesn’t mean you’ll have to pay $22.5 in interest. In fact, your monthly statement at day 30 will show $1,500, the raw average daily balance without the interest.

Let’s assume that the bank offers a 21-day grace period expiring on day 51 (21 days after day 30), and you pay $1,500 toward your balance on day 45, which is way before the grace period expires. The interest accumulated, $22.50 will be canceled! And you will never be billed for this amount. The first time I heard of the “grace period” concept, I thought it was an amazing grace.

The $0 at day 60 assumes you don't charge your credit card during the 2nd billing cycle.
The $0 at day 60 assumes you don’t charge your credit card during the 2nd billing cycle. Point is, no interest is charged.

The grace period only applies if you have no balance carried over from the previous billing cycle. In our first example, the initial $1,000 was carried over from the previous billing cycle. In the second example, no balance is carried over, and the grace period applies. In case you flop and not fully pay the statement balance of $1,500 by the end of day 51, the entire interest amount of $22.50 will be charged on the next monthly statement.

To make it more complicated, the grace period applies only to the portion of the balance that results from purchases. Cash advance doesn’t have a grace period; you will always be charged the full amount of interest if you withdraw cash from an ATM using a credit card.

So what do we learn from these two examples?

1, Pay your balance as soon as possible to keep the average daily balance low.

2, Interest starts accumulating the day you make a purchase.

3, Pay off your balance during the grace period each month to cancel all interest charges. The end of the grace period is typically the minimum payment due date.

4, Minimize cash advance which doesn’t have a grace period.

So … I hope I have answered the original question. If there’s anything that needs clarification, please let me know in the Comments section below.

Hope you all have a sunny weekend!


Richard (Hiep Tran)

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