How Credit Card Finance Charges are Calculated
Interest rates and the method by which finance charges are calculated vary from one credit card company to another. Fortunately, they must by law disclose the interest rate that they charge as well as the method which they use to calculate the charges that are added to your account.
Generally speaking, credit card companies charge relatively high rates of interest on unpaid balances. Some calculate interest with a fixed rate that rarely changes. Others charge variable interest rates on their balances, usually equal to the prime rate (the interest rate that commercial banks charge their most creditworthy borrowers) plus 2 to 7 percent, depending on the policy of the particular financial institution.
Many credit card companies allow a grace period of twenty to twenty-five days beyond the billing date, during which time you can avoid interest charges by paying the balance of your account in full. A number of companies, however, are moving away from this standard, giving smaller grace periods or none at all (which means that interest charges begin to accrue on your purchases as soon as they post to your account).
Finance charges are calculated by applying a periodic interest rate to the outstanding balance of your account. Credit card companies use several methods to determine the balance in an account that’s subject to interest charges. The periodic rate is calculated by dividing the annual percentage rate (APR) by the number of billing periods in a year, generally twelve. An APR of 18% would, therefore, convert to a period rate of 1.5% (18 divided by 12 = 1.5) per billing period when finance charges are calculated monthly. The periodic interest rate is then multiplied by the balance to determine the dollar amount of the finance charge.
If your credit card has a grace period and you normally pay your balance in full and on time every month, you normally will not incur any finance
charges at all.
However, if you regularly carry a balance on your card, the method that’s used to calculate that balance is crucial because it plays a large part in determining how much interest you’ll have to pay. Be aware of how interest charges are calculated on your accounts. The most common methods used are listed here:
- Adjusted balance - In this method the balance at the beginning of the billing cycle is adjusted downward for payments made during the cycle, but the balance is not adjusted upward for purchases made during the same cycle. Payment date is irrelevant as long as it’s posted during the cycle. The resulting balance after calculations are completed is multiplied by the periodic interest rate to determine the finance charge for that billing cycle. This is the most favorable method, since it results in the lowest finance charge.
- Average daily balance - The balances in your account during each day of the billing cycle are added together, and the sum is divided by the number of days in the cycle. Payments made during the cycle are subtracted from the amount you owe; new purchases may or may not be included in the calculation, but usually are.
- Two-cycle average daily balance - The balances in your account during each day of the last two billing cycles are added together, with the sum being divided by the number of days in the two cycles. The remaining calculations are similar to the average daily balance .
- Previous balance - The periodic interest rate is applied to the billing cycle beginning balance; no payments or purchases made during the month are included in the calculation.
- Ending balance - The periodic interest rate is applied to the billing cycle ending balance. The timing of payments and new purchases is irrelevant since only the cycle’s closing balance is used in the calculation.