Dec 16, 2010 Evan Dicken
Credit card debt is a growing problem in America. Last year, the Obama administration passed sweeping reforms that limited various fees, and required banks to be more upfront about payment schedules and interest. One factor that was not addressed in the 2009 Credit Card Act was the interest rate structure itself. Additionally, many consumers remain unfamiliar with the methods banks use to calculate interest on their credit balance. This information is no "magic bullet" for debt relief. However, a basic of how credit card interest "works" is a fundamental step towards planning for financial independence.
One of the most common credit card misunderstandings involves Residual Interest. Residual Interest occurs when a cardholder who usually carries a balance from month to month pays off the entire amount in full. Unfortunately, just because the balance has been reduced to zero does not mean that there are no more interest charges to pay. Many consumers are surprised the month after paying down a large balance by a letter from the bank saying that they still owe several hundred dollars (or more) in interest. If left unpaid, residual interest can even form a new balance on the card which can in turn create more interest, restarting the cycle of debt.
Residual charges are a function of how most banks assess interest rates. Although charges are compiled monthly, they are actually assessed daily. Basically, at the end of the billing cycle the bank takes the balance the account held at the close of every business day, adds them together, divides them by the amount of days in the cycle, and then assesses interest on each day to produce a monthly bill. The simplest way to represent this is:
(D1 + D2 + D3…) x (APR/365) = Interest Charge
D = Balance at the close of a particular day
APR = Annual percentage rate on a credit card
365 = The number of days in the year (remember the 'A' in APR stands for 'Annual.')
Because most consumers get a bill at the end of the month, they assume the charges are monthly, when in reality the bank only does the math at the end of the month. Since charges accrue daily, even if a consumer pays his or her balance down to zero he or she is still responsible for the interest that accrued for that portion of the billing cycle that he or she carried the balance. These leftover daily charges are what are known as "Residual Interest." If it sounds a bit confusing, that's because it is. Let's plug some numbers into our formula to represent a normal billing cycle.
For simplicity's sake, let us say the cycle is only five days long and the interest rate is 20%. The customer carried a $10,000 balance from last month. On day one $200 in purchases are made, on day two $300 are made, day three $100, day four nothing, and day five $400. So the customer's balance would look like this:
Initial = $10,000
D1 = $10,200
D2 = $10,500
D3 = $10,600
D4 = $10,600
D5 = $11,000
So our formula would be:
(10,200 + 10,500 + 10,600 +10,600 + 11,000) x (.20/365)
52,900 x .000548 = $28.98
$28.98 may seem like a small amount of interest on over $10,000, but remember that our imaginary billing cycle is only five days long. If the customer made no more purchases for the rest of the month and we assume a normal billing cycle of around 30 days, the interest actually charged would be around $175.00!
Now that we understand how interest is assessed, it's time to tackle residual finance charges. The example above assumes that the consumer is making no payments on the card during the billing cycle, but what if he or she pays off the balance in full mid-way through the cycle? Let's increase the number of days in the cycle to 30, and say that the customer pays off the total balance on day six. So our balance would look like:
D1 = $10,200
D2 = $10,500
D3 = $10,600
D4 = $10,600
D5 = $11,000
D6 = $0
D7 = $0
Etc.
…and our formula would be:
(10,200 + 10,500 + 10,600 +10,600 + 11,000 + 0 + 0 + 0 etc.) x (.20/365)
52,900 x .000548 = $28.98
Since the interest is charged daily, the customer is still responsible for those five days in the billing cycle that he or she carried the balance, even though it was paid in full on day six. No interest is charged from the day the balance was paid onward, but the customer is still going to get a bill for $28.98 for the first five days when he or she did have a balance. That is a residual interest charge.
There is no way to avoid residual interest except to pay your bill, in full, on the day that it is calculated. This is not possible through traditional mail (as it takes several days for the credit card bill to reach a consumer's home…several days you are being charged interest), but can be done online if a consumer is aware of his or her cycle dates, or sets up some sort of direct payment.
Fees and interest charges represent the credit card companies' largest single source of income. Some are inescapable, but the vast majority can be lessened or avoided entirely by simply understanding how and when they are assessed, and making sure that you do not run afoul of any credit card pitfalls.
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