If you've been trying to learn more about the different types of loans and debt accounts, you may have heard the term "simple interest." You may wonder what this is compared to credit card interest – the difference is in how the lender calculates the interest. When you take the time to understand the various ways interest is determined, you can make informed decisions about your personal debt accounts.
Unlike simple interest that only applies to the principal, credit card interest compounds so that you also pay interest on the interest you're charged.
How Simple Interest Works
Simple interest is just as the name states — a very simple way to calculate interest due on a credit account. It is the principal, or amount borrowed, multiplied by the rate agreed upon between the lender and borrower multiplied by the number of years the account is to be repaid. So, for instance, if you borrow $1,000 at a 5 percent interest rate for three years, the simple interest due on the account is $150 ($1,000 x 0.05 x 3). This represents the total interest the borrower has to pay on the account, which commonly gets divided into equal payments along with the principal amount due.
Benefits of Simple Interest
Simple interest is not common for a revolving account like a credit card. This method of calculating interest is more common for an installment loan – usually a personal loan between acquaintances that will last for only a short period of time. It's beneficial for a borrower because the interest charge is based on principal only and is calculated only once – at the very beginning of the loan.
With other calculation methods, interest is charged at the beginning of every period (such as monthly or yearly), which sometimes makes the loan more expensive. Simple interest calculation isn't as beneficial for the lender because it does not maximize his potential profit from the loan.
How Credit Card Interest Works
Credit cards compound interest, which means they charge interest on interest. Compare this to a simple interest rate account, which charges interest only on the principal balance.
With credit cards, the interest gets calculated at the end of each period. In some cases, this occurs each month. In other cases, the calculation occurs at the end of each day of the month, called daily accrual. The interest continues to accumulate indefinitely or until you finally pay off the balance, including interest.
Daily Average Balance Example
Some credit card companies determine interest charges based on the average daily balance. Say you have a balance of $5,000 at the beginning of the month with an interest rate of 12 percent (0.12 in decimal form). The daily rate is 12/365 (days in the year), which equals 0.000329.
At the end of the first day, you're assessed $1.64 in interest (0.000329 x $5,000). The new balance you're charged interest on is $5,001.64. At the end of the next day, your interest charge is $1.65. This amount is added to your balance, which now equals $5,003.29.
This accumulation continues until the end of the monthly statement period, when the total balance for the day is divided by the number of days in the month to determine the average daily balance. The creditor uses that balance to figure your interest cost for the month. So, as you can see, the way some creditors calculate interest on a credit card – compared to the simple interest calculation – is very beneficial to the lender. Take this example into account before you start using and maintaining a balance on credit cards.