If your credit card's annual interest rate is 18%, that doesn't mean you will be charged 18% interest each year. Depending on how you manage your account, your actual interest rate may be higher or lower. It could even be 0%. This is because interest is calculated on a daily basis, not on an annual basis, and interest is only charged if you have a monthly debt.

Knowing how credit card issuers calculate interest can help you understand the true cost of debt.

1. Convert annual rate to daily rate

Your interest rate is determined on your statement as the annual interest rate, or APR.

Because interest is calculated on a daily basis, you need to convert APR into a daily interest rate. Divide by 365. Some banks divide it by 360; for our purposes, this difference is not worth worrying because it only changes a little bit. The result is called the periodic interest rate, sometimes called the daily cycle rate.

2. Determine your average daily balance

Your bill will tell you which days the billing period includes. Your interest expense depends on your balance every day.

You start with your unpaid balance - the amount carried over from last month. When you shop, the balance will increase; when you pay, the balance will decrease. Use the transaction information on the statement to view the billing cycle day by day and note the daily balance. Once completed, add all daily balances and divide by the number of days in the billing period. The result is your average daily balance.

3. Put them together

The final step is to multiply the average daily balance by the daily rate and multiply the result by the number of days in the billing period. Depending on whether the issuer is accrued on a daily basis or on a monthly basis, your actual interest expense may be slightly different from this calculated amount. Compound interest is the process of adding accrued interest to the unpaid balance so that you can pay interest.

Compound interest is the reason why you pay interest for more than four months. For example, suppose your average daily balance for the year is exactly $1,000. If the bank only receives 18% interest at the end of the year, you will have to pay $180. But because of your interest compounding, you will actually become a hook close to $195.

How does credit card interest work?

Credit card issuers will only charge interest on your purchase history from one month to the next. If you pay the full amount every month, your interest rate doesn't matter, because you won't be charged interest at all. Obviously, full payment is the most cost-effective method, but if you usually hold a balance, a low-interest credit card can save you interest.

After seeing the results, you'll find a way to quickly reduce interest: pay twice a month, or more often, not once. That extra payment will reduce your average daily balance and thus reduce your interest. Suppose you have a $2,000 balance and you have $1,000 on your credit card statement. If you pay $1,000 on the 20th day of the 30-day billing period, your average daily balance is about $1,633. But if you pay $500 on the 10th day and $500 on the 20th day, your average daily balance will be $1,467. Your interest rate will be reduced by about 10%

Depending on your card, you may have different APRs for different types of transactions, such as purchases, balance transfers, and cash advances.