How Do Banks Calculate Interest?

By |

Using a credit card will not only make your life colorful, but also bring a lot of convenience. But do you know how banks calculate interest? Correctly understanding and calculating the Annual Percentage Rate (APR) of your credit card interest will help you plan your credit card usage.

I’m going to share a little bit about credit card interest, hoping to help you understand the credit card interest rate APR better. So that you will not only understand bank charges, but also build good relationships with various banks.

What is Nominal Rate?

APR usually refers to the Nominal Rate. Because banks actually calculate interest according to the Effective Rate. If we do not make the payment in time after the consumption, the bank will charge the corresponding interest according to the agreement at the time of issuing the card.

What is Effective Rate?

Assuming that a credit card has an APR of 20%, if you owe $1,000, the bank’s one-year APR is:

$1,000 * 20% = $200

But that’s not the case.

An APR of 20% means that the monthly interest rate is 20/12 = 1.667%.

So the annual interest is: $1,000 * (1+0.01667) ^12 – $1,000 = $219.43

The effective rate is actually 219.43/1000 = 21.94%

How does the bank calculate interest?

The bank calculates the interest based on what it owes each day:

APR of 20% means a daily (for 365 days) interest rate of 0.05479%. Let’s do the same example. So the interest for one year is:

$1,000 * (1+0.0005469) ^365 – $1,000 = $221.8

The effective rate is actually 221.8/1000, which is 22.18%

22.18% (Effective Daily Rate) > 21.94%(Effective Monthly Rate) >20%(APR, Nominal Rate)

So we’re actually paying $21.8 more in interest than we thought. The more time goes by, the more effective the rate goes up, not the 20% we thought it was.

Knowing how Banks calculate interest will help you spend more wisely.

Select a credit card or check your credit scores and reports for free anytime.

Note: This post contains pictures from networks and copyrights belong to original authors.