Credit Card Daily vs Monthly Compounding: Does It Make a Difference In How Much Interest You Pay?

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Credit card companies typically use daily or monthly compounding when calculating the interest bill on a credit card balance. Does it make a difference? Is one way more expensive than the other for the borrower? We’ll shed some light on how daily vs monthly compounding works.

Credit cards are super convenient, but they can be costly if you carry large balances over the long term. Credit card interest rates tend to be much higher than many other loan products.

In this article, we’ll break down the key factors that contribute to credit card interest costs and demystify the difference between daily vs monthly compounding.

Credit Card Interest Basics

A credit card balance is technically a loan from the credit card issuer. Like any other loan, banks charge interest for the privilege of borrowing the money.

When you make a purchase using your credit card and carry a balance beyond the grace period, interest starts accruing on the balance.

How much interest you’re charged depends on the annual percentage rate (APR) and how the interest is compounded, whether its daily vs monthly compounding.

To understand the difference between daily vs monthly compounding, it’s important to be familiar with a few key components of the credit card interest calculation: the average daily balance, the Annual Percentage Rate (APR), and how often the interest is compounded.

Average Daily Balance

Credit card companies use the average daily balance method to calculate interest charges.

To calculate your average daily balance, the credit card company totals the sum of your daily balances and divides by the number of days in the billing cycle:

This involves calculating the average balance you owed each day throughout the billing cycle. The formula for average daily balance is:

Sum of Daily Balances / Number of Days in Billing Cycle = Average Daily Balance

Let’s break it down with a simple example. Suppose you have the following daily balances over a billing cycle:

  • Day 1: $500
  • Day 2: $600
  • Day 3: $700

After summing up these daily balances, let’s say the billing cycle is 30 days. The average daily balance would be:

($500 + $600 + $700) / 30 Days = $600 Daily Balance

This average daily balance is then used in conjunction with the APR to calculate the monthly interest.

Annual Percentage Rate (APR)

The APR is the annualized interest rate that credit card companies charge on outstanding balances. It’s expressed as a percentage and represents the cost of borrowing money over the course of a year.

Credit card APRs vary widely. A single credit card may also have different APRs for purchases, balance transfers, and cash advances.

If your credit card has a 20% APR and you carry a $1,000 balance for a year, it would be easy to assume that your interest costs should be $200 for the year.

In reality, there’s more to the calculation than that. The actual interest you pay could vary depending on whether the card issuer uses daily vs monthly compounding.

Daily vs Monthly Compounding

To calculate the actual interest accrued on your credit card balance, we have to take into account daily vs monthly compounding.

To see how this works, let’s first calculate the interest as if it is compounded monthly.

For this example, let’s assume the APR is 20% and the average daily balance is $500. To calculate the monthly interest rate, we divide the APR by 12:

20% APR / 12 Months = 1.6667% Monthly Rate

To calculate the interest, we multiple the monthly rate by by the average daily balance:

1.6667% Monthly Rate * $500 = $8.33 Interest

Now, if we maintained a $500 balance every day for a year, the total interest costs add up to $100, which is exactly 20% of $500. The APR quotes the actual interest costs exactly.

Now, what happens if the interest is compounded daily? How does that work? Again, let’s assume a 20% APR and a $500 average daily balance.

For this calculation, we first need to calculate the daily interest rate. Some credit card companies assume 365 days in the year, others use 360. We’ll use 360 here:

20% APR / 360 Days = 0.05556% Daily Rate

If we use the same average daily balance of $500, then the interest calculates as follows:

0.05556% Daily Rate * $500 = $8.12 

Interestingly, the daily compounding actually comes out a little cheaper than the monthly compounding interest. If the credit card issuer uses 365 days to calculate the daily rate, then it would potentially even be a little less.

In the grand scheme of things, daily vs monthly compounding interest doesn’t make much of a difference on the total interest you pay on a credit card balance.

If you’re interested, you can do your own daily vs monthly compounding interest calculations using this simple credit card interest calculator.

Grace Periods and Avoiding Interest

Most credit cards come with a grace period, which typically ranges from 21 to 25 days.

If you pay your balance in full during the grace period, you won’t incur any interest charges on your purchases. However, once the grace period expires, interest will start accruing on the balance.

To avoid paying interest, make it a habit to pay your credit card balance in full before the grace period ends. That way, you can enjoy the benefits of using a credit card (including earning points) without incurring interest costs.

Impact of Minimum Payments

Credit card companies usually require a minimum monthly payment that equals a small percentage of the outstanding balance.

Making the minimum payment helps you avoid late fees, but it doesn’t help you avoid interest charges. If you make only the minimum payment, you’ll continue to accrue interest on the remaining balance.

Additionally, minimum payments pay off your balance very slowly. Depending on the interest rate, it could take years – or even decades – to pay off your credit balance if you make just minimum payments.

Paying more than the minimum can significantly reduce the total interest paid over time. If possible, aim to pay your balance in full each month to maintain financial health and minimize interest expenses.

Consolidate Your Credit Cards

If you have a lot of credit card debt, it’s probably costing you a lot of interest and damaging your credit.

If you’re a homeowner, check out this little-known home equity “loan” many Americans are using to consolidate credit card debt with no monthly payments or interest charges.

Mike Roberts
About Mike Roberts

Mike Roberts is the founder of HEAZone.com, a published author, and a highly experienced veteran of the mortgage industry. When he's not working, he enjoys spending time with his family, skiing, camping, traveling, or reading a good book. Roberts is the author of The Reverse Mortgage Revealed: An Industry Insider’s Guide to the Reverse Mortgage, which is available on Amazon.

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