Compounding interest on your credit card works against you. Here's how to beat it
Credit cards are designed from the ground up to keep extracting money from your pocket as efficiently as possible and for as long as possible, and it starts the second that you're late on a single payment. Here are five things you need to know about credit cards and compounding interest -- and how to beat it.
1. The APR on your credit card doesn't give you the full picture
Most of us know that our credit cards come with a quoted interest rate, and that's the amount of interest our balance would generate over the course of a year if we didn't pay it off at all. This is called the APR.
At first glance, then, you might expect that a $1,000 credit card with a 29.9% APR would generate $299 in interest charges over the course of a year, right?
Nope. After a year, the balance on your credit card would actually be $1,353.95.
So, where did that extra $54.95 come from? It came from daily compounding.
2. Your credit card interest is compounded daily, not annually
If you were expecting that a $1,000 balance on a 29.9% credit card would generate $299 in interest over the course of a year, you'd be right if that interest were compounded annually, but that's not how credit cards work. Instead, they compound daily.
What's the difference? Daily compounding means that the credit card company calculates the interest you owe daily and adds that to the card's balance.
So, that $1,000 credit card balance on the first day of the year would earn one day's worth of interest. That's 29.9% APR divided by 365 days in the year or 0.082%. That's about $0.08, roughly. The credit card company adds that $0.08 to your card balance.
The next day, interest is calculated on your new balance of $1,000.08. That's going to be another $0.08.
This is all fine and dandy, but the credit card company keeps track of fractions of a cent with these calculations, and eventually, the interest you earn each day ticks up to $0.09, then to $0.10 and so on. That's where the extra $54.95 comes in.
3. You have a grace period between your credit card statement being mailed to you and the due date
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Each month, your credit card company issues you a statement listing all of your credit card expenses since the last statement. That's often called the statement date.
Your bill comes with a minimum amount due and the due date.
By law, there must be at least 21 days between the statement date and the due date. Furthermore, the bank cannot charge you interest on new expenses between the statement date and the due date. If you buy something in October and your credit card company issues you a statement on November 1, and it's due on November 22, those new expenses don't start receiving interest until November 22.
There's a catch, though.
Also: How to save money with a balance transfer card
4. The grace period only happens if you aren't carrying a balance on your credit card
As soon as you don't pay off your card in full by the due date, that grace period goes away. Instead, purchases you make on your credit card start to accrue interest immediately, as soon as you make them.
This makes a big difference. If you put $1,000 on your 29.9% interest credit card, do not have an ongoing grace period, and don't pay it off for 30 days, you accumulate $25.22 in interest. That's tacked right onto the balance, so it will keep growing and building moving forward.
On the other hand, if you have been paying off your credit card in full and have a grace period, you owe no interest on that expense.
5. To get the grace period back, you have to pay off the card in full two months in a row
Paying off your credit card alone won't get you your grace period back. You have to do it twice in a row.
This is because, even if you pay off everything on your bill, it still accumulates interest between when the bill was sent to you and when you paid it off. That extra accumulated interest will show up on your next bill, which you also need to pay off in full to get your grace period reinstated.
Here's how to beat daily compounding credit card interest
The moral of this long story is that carrying a balance on your credit card past the due date on your statement is even worse than you think. Not only does it start accumulating interest at that point, but you lose your grace period, meaning that new expenses on your card start accumulating interest immediately.
The solution is simple: pay off your credit card in full and keep it that way.
Simply pay off your full credit card balance two months in a row, and your grace period is restored. Going forward, you'll see no interest charges on your statement as long as you keep paying off all of your new charges in full.
At that point, a credit card becomes a convenient tool rather than a source for debt. It makes many types of payment much easier, and if you have a good rewards program on your card, it accumulates rewards effortlessly.
Also: The best credit card points to redeem for gift cards
One good practice to make this easier is to only use your credit card for certain kinds of purchases. For example, you might choose to use a BP Visa solely for buying gas or an Amazon Visa solely for buying things from Amazon and use your bank's debit card for other things. This helps you keep your card spending in check, so you don't fall back into owing interest and losing your grace period.
[This article was first published on The Simple Dollar in 2020. It was updated in March 2022.]