How is Credit Card interest calculated?

While most people have a very good understanding of what a credit card is and that they incur interest charges on their credit cards, very few people understand how interest charges are actually calculated on their credit cards.  Here, we give you a detailed description of how credit card interest charges are calculated.

In the UAE most banks communicate their credit card interest rates as a monthly percentage rate, for e.g. the ADCB Touchpoints Infinite credit card has an interest rate of 3.25% and the Emirates Citibank Ultima credit card has an interest rate of 2.99%.  To understand how interest is charged on the credit card, we need to first convert these monthly rates into an annual rate of interest. This is done by multiplying the monthly interest rate by 12 which gives us what is known as the “Annual Percentage Rate” or APR for short.

Credit card interest is calculated using the APR.  This is the interest rate, expressed as a yearly (hence annual) rate of interest.  However, banks calculate interest on the credit card outstanding balance on a daily basis.  To do this, the annual interest rate (APR) applicable on the card is divided by 365. The resultant daily rate of interest is multiplied by the total outstanding balance as on that date to arrive at the interest charge for that particular day.  This process is repeated daily until the entire outstanding balance amount is paid off in full.

To illustrate this with an example, assume that you have an amount outstanding on your credit card of AED 10,000 and let’s assume the monthly interest rate on the credit card is 3.25%.  

• We first find the APR by multiplying the monthly interest rate by 12.  This gives us an APR of 39%, which is the annualized interest rate for the card.
• Next, we arrive at the daily rate of interest by dividing the APR by 365, hence we get a daily interest rate of 0.1068% (39%/365).  
• The interest charge for the day is calculated by multiplying the outstanding balance as of that day (which in this example we have assumed to be AED 10,000) and the daily interest rate (which we have just calculated to be 0.1068%).  Thus, we arrive at an interest charge of AED 10.68 (10,000*0.1068%).
• This interest charge of AED 10.68 is then added to the outstanding balance amount due, so the new outstanding balance on the credit card becomes AED 10,010.68.  
• If there have been no purchases or payments made on the same day, then the opening outstanding balance on the next day will be this figure of AED 10,010.68.  
• The interest charge for the next day will be calculated using this new outstanding balance amount.  Hence, in our example the interest charge for the next day will be 10,010.68 * 0.1068% which is AED 10.69 making the new outstanding balance amount AED 10,021.38.
• While these amounts may not initially seem significant, it is very important to realise that they can add up very quickly to become significant amounts.  In this example, simply continuing this calculation and assuming no payments or additional purchases are made, the outstanding balance increases to 10,150.63 which represents interest charges of AED 150.63 in just 15 days.  
• What is also critical to note is that this amount does not increase uniformly over each day but is in fact compounding because interest for each day is also calculated on interest that was charged for every day prior to that.  In our example, after 30 days the outstanding balance increases to AED 10,314.54. The total interest charges in the first 15 days was AED 150.63 but the interest charges over the next 15 days totaled to AED 163.91. This figure would only keep rising with time unless payments are made to reduce the outstanding balance.