If you’ve paid attention to your credit card statement, you’ve noticed a finance charge on balances that you didn’t pay in full. The finance charge is an interest fee that’s added to your purchases and fees. Your finance charge will be higher the higher your balance and interest rate are. Most credit card issuers charge a minimum finance charge if the calculated finance charge is low.
There are six different ways that finance charges are calculated. They’re all based on some variation of your credit card balance during the billing cycle. Your balance is multiplied by your periodic rate rather than your annual percentage rate. The periodic rate is expressed on a monthly or daily basis.
Six Finance Charge Calculation Methods
1. Average Daily Balance
The average daily balance method of calculating finance charges is the method that’s most commonly used. In this method, your creditor averages your balance for each day during your billing cycle. Then, the average is multiplied by your annual percentage rate and the number of days in the billing cycle and the final number is divided by 365. The calculation looks like this:
( Average daily balance * APR * number of days in billing cycle )/365
2. Daily Balance Method
To calculate your finance charge using the daily balance method, your credit card issuer multiplies the balance on each day in the billing cycle by the daily rate to come up with a daily finance charge. Then, the daily finance charges are added together for your finance charge for the month. The daily rate is your annual percentage rate divided by the number of days in the year.
3. Ending Balance Method
If your credit card issuer uses the ending balance method to calculate your finance charge, then the balance at the end of your billing cycle is multiplied by the periodic rate to come up with your finance charge. To calculate your ending balance, your card issuer takes the balance at the beginning of your billing cycle then subtracts credits and payments and adds fees and new charges.
4. Previous Balance Method
The previous balance method multiples your balance at the beginning of the billing cycle by the periodic rate. Any payments or charges you make on your credit card during the billing cycle won’t affect your finance charge, at least not in this billing cycle. The balance at the end of your current billing cycle will be the balance at the beginning of your next billing cycle. So what you charge this month will impact the finance charge you pay next month.
5. Adjusted Balance Method
The adjusted balance method begins with the balance at the beginning of your billing cycle. The balance is adjusted based on any payments or credits made during the billing cycle. That adjusted is multiplied by the periodic rate to come up with your finance charge. You won’t pay a finance charge on charges you make during this billing cycle until the next billing cycle.
6. Double Billing Cycle Method
The double billing cycle method of calculating finance charges is the most expensive method of calculating finance charges. The calculation method is exactly like the average daily balance method of calculating finance charges, except the average daily balance from the current and previous billing cycles are used. That means, you end up paying interest on balances that have already been paid.
Fortunately for credit cardholders, a federal law that becomes effective February 22, 2010 bans the double billing cycle method of finance charges.
Which Method Does Your Card Issuer Use?
Federal law requires credit card issuers to give include details about the finance charge calculation on your billing statement. Refer to the back of your billing statement for details on which finance charge calculation method your card issuer uses. Your billing statement will describe how your finance charge is calculated even if it doesn’t specifically name the calculation method as we did in earlier in the post.
How to Avoid a Finance Charge
Finance charges are applied to balances that you carry beyond the grace period. You can avoid paying a finance charge by paying your balance in full before the grace period expires. Because credit card issuers are currently required to mail your billing statement 14 days before the due date, you may have to pay your balance before the billing statement comes. (As of February 22, 2010, billing statements must be mailed at least 21 days before the due date.)
You can only avoid a finance charge if you had a $0 balance at the beginning of the billing cycle. Otherwise, you won’t have a grace period and won’t be able to avoid the finance charge.
Cash advances and balance transfers typically don’t have a grace period. Instead, those balances begin incurring interest the day the transaction is complete. Unfortunately, you won’t be able to avoid a finance charge on either of those transactions. You can reduce the finance charge you owe by paying the balance sooner rather than later. That’s actually better in this situation since cash advance and balance transfer balances have a higher interest rate.
The finance charge for purchases, cash advances, and balance transfers are all calculated separately.
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