In the current times, people have stopped stacking currency notes and coins in one’s wallet. All of us have entered the digital era where all transactions are done either through online platforms or through plastic currencies i.e. debit cards and credit cards. In debit cards, it is important that you have an account with the bank with sufficient balance, but in credit cards, this is not important. Credit cards are like a loan with the only difference that loans are to be repaid on a periodic basis whereas credit cards are a revolving form of borrowing.
Credit cards are a boon for all those who do not want to pay for their purchases in cash. It allows you to borrow money from the bank so that you can purchase whatever you want. It also helps to build your credit score. A good credit score helps you avail loans more easily in future. It also helps in getting lower insurance premiums and also offers various rewards. Keeping aside all its benefits, credit cards can turn out to be dangerous. But they are also a powerful tool if you use them wisely and responsibly. It is important to understand the working of credit cards thoroughly in order to make the best use of credit cards.
Before understanding the working of credit cards and their interest calculation it is important to know about some terms:
- Annual percentage rate (APR): The annual percentage rate (APR) is the interest rate charged on credit card balances expressed in a standardized, annualized way. This rate is applied each month that an outstanding balance is present.
- Payment Due date: “Payment Due Date” means the date every month, on which the payment in respect of the charges incurred by usage of the Card by the Card Member falls due as communicated through the Statement.
- Credit Limit: The Credit limit is the maximum amount you can spend or borrow using your Credit Card. This limit is determined by various personal details like your income, source of income, etc.
- Grace Period: Most credit cards provide a grace period to the cardholders. A grace period is a time given to credit cardholders to pay off their credit card bills without incurring any interest on the outstanding amount. Grace period is also known as interest-free credit period. The time period varies depending on the banks and the type of card. Generally, banks provide a minimum grace period of 20 days to their cardholders, starting from the day they receive their credit card bills. In India, most banks offer a maximum grace period of 50 days.
- Billing cycle: The billing cycle for a credit card is the period of time between billings. For example, a billing cycle may start on the 1st day of the month and end on the 30th day of the month. Or, it may go from the 15th of one month to the 15th of the next. Billing cycles are varying lengths, ranging from 20 to 45 days, depending on the credit card and the issuer.
During the billing cycle, any purchases, credits, fees, and finance charges are posted to your account and added or subtracted from your balance. Then, at the end of the billing cycle, you are billed for all unpaid charges and fees made during the billing cycle. Any activity on your account after the billing cycle ends will appear on your next billing statement.
Your next billing cycle will start with whatever balance was left unpaid at the end of the previous billing cycle. Then, when your next billing statement comes in the mail, it will only include the transactions made to your account during that particular billing cycle. If you’ve ever had to go back and look at previous billing statements to find a transaction, that’s why. Your credit card payment due date is generally about 21-25 days after your billing cycle ends. This means you’re not required to send payment for purchases until the very next billing cycle after you’ve made them. There’s a period of time between your billing cycle end date (which is also your account statement closing date) and your bill due date is known as the grace period. You can typically pay your balance in full before the end of the grace period to avoid paying interest on your balance as long as you paid your last statement balance in full last month.
- Billing statement: it is a statement that lists all the purchases, payments, and other debits or credits made to your account within the billing cycle.
- Interest rate: If the cardholder does not pay the full credit card bill before the due date, the entire outstanding balance will attract the applicable rate of interest for credit cards. Not just the balance, any new spending on the card will also have these interest rates applicable until the entire balance has been paid off. As in the case of a cash advance, unless the cardholder pays off the entire bill balance each month, there will be no grace period for them. Being late on paying credit card bills is referred to as default. Late penalty fee can also be applied to the accumulated credit card debt.
The interest charges are calculated by the banks on an average daily balance method on the basis of monthly percentage interest rate.
Interest calculated = [(outstanding amount x interest rate per month x 12 months) * number of days] / 365
Let’s understand the interest calculation on credit cards with the help of an example.
Example: Mr A has bought a credit card. The due date of the credit card taken by him is 18 November of every month. It means that the credit card bill should be repaid before 18th of every month. The credit card company charges 2.65% monthly interest rate and a late payment penalty of Rs.250.
The Credit Card charges Rs.350 as the late payment fees for credit card bills up to Rs.10,000, Rs.500 for bills between Rs.10,000 and Rs.20,000 and, Rs.600 for bills above Rs.20,000. Depending on the outstanding balance this amount can really add up.
Since the payment didn’t reach the credit card company on time, the entire outstanding balance will attract interest rate and a late payment penalty.
The charges are calculated from the statement date.
- Interest on Rs.20,000 @ 2.65 per cent pm from 18 November to 15 December (i.e. for 28 days)[(20000 x 2.65 x 12 x 28)/365]/100 = Rs 487.89
- Interest on Rs 15,000 @ 2.65 per cent pm from 15 December to 17 December (i.e. for 3 days)((15000 x 2.65 x 12 x 3)/365]/100= Rs 39.20
- Interest on Rs 5,000 @ 2.65 per cent pm from 18 November to 17 December (i.e. for 30 days)((5000 x 2.65 x 12 x 30)/365]/100 = Rs 130.68
- Interest on Rs 4,000 @ 2.65 per cent pm from 17 December to 18 December (i.e. for 2 days)((3000 x 2.65 x 12 x 2)/365]/100 = Rs 6.96
- Interest on Rs 1000 (fresh spends @ 2.65 per cent pm from 16 December to 18 December (i.e. for 3 days)((1000 x 2.65 x 12 x 3)/365]/100 = Rs 2.61
- a) Thus total interest = (487.89+ 39.20+130.68+6.96+2.61) =Rs 667.34
- b) Late payment charges = Rs 350
- c) Total principal amount outstanding = Rs 5000 (Rs 1000 fresh spend + balance Rs 4000 outstanding from last month’s billing period)
Hence Total Amount Due = (a) + (b) + (c) = Rs 6017.34 + service tax as applicable on interest and other charges.
This example gives you an idea of how the interest calculation take place if you do not pay your dues on time. The interest calculation of a credit card is a complicated process. An easy way to understand this is to calculate interest on each purchase separately.
In the above example, Mr. A purchased furniture worth Rs.20000 on 10th Nov. He is supposed to repay this amount before 18th Nov, but he is unable to do so. Now the credit card company will start charging interest on this amount from 18th Nov to 15th Dec (Payment to the credit card company). Mr. A doesn’t repay the entire amount so for the remaining balance i.e. Rs.15000 interest will be charged from 15th Dec to 17th Dec (payment made to the credit card company). Now this Rs.20000 balance is clear.
The second purchase made by Mr. A is of Rs.5000, purchase of apparels on 15th Nov. interest will be charged on the amount from 18th Nov to 17th Dec. Now Rs.5000 is not paid in full, only Rs.1000 is paid. For the remaining Rs.4000 interest will be charged for a day.
Mr. A made a fresh purchase of Rs.1000 on 16th Dec on which interest will be charged from 16th Dec to 18th Dec. This amount is unpaid yet.
Now all of this interest needs to be paid along with the outstanding balance as soon as possible. If this payment is not paid then the interest will keep on accumulating till the interest is finally paid.
NOTE: Cash advances do not enjoy any grace period. This means that if you take cash from your credit cards then no grace period will be given to you, as available when purchases are made through the card. So in case you withdraw cash from your credit card then the interest will be charged from the very first day and it will continue till the amount is paid in full.