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.

Related posts:

1. Fiscal Fizzle Carnival of Personal Finance
2. 5 Reasons to Avoid a Credit Card Cash Advance
3. The 8 Most Important Credit Card Terms

What is an interest rate?

The interest rate is most often stated as an annual percentage rate. This is the annual cost of carrying a balance on your credit card. Since credit card interest is charged on a monthly basis, credit card companies typically use a periodic interest rate which is just your APR divided by the number of billing periods in the year. For example, if your APR is 12% and you are billed 12 times a year, your periodic interest rate is 1% (12 divided by 12).

How does the interest rate affect my credit card?

Your interest rate, or APR, comes into play when you carry a credit card balance beyond the grace period. The grace period is the amount of time you have to pay off a credit card balance without receiving interest charges. Grace periods are typically 21 days.

When you carry a credit card balance, your balance is multiplied by your periodic rate to come up with your finance charge – that’s the monthly interest charge you pay. The higher your interest rate, the higher your finance charges will be.

Types of Interest Rates

There are several different types of interest rates. We’ve already discussed the annual percentage rate and the periodic rate. There are more.

Variable vs. fixed interest rate

A fixed interest rate is an interest rate that doesn’t (easily) fluctuate over time. Fixed credit card interest rates are allowed to increase, but only under circumstances and you must be notified before the interest rate increases.

A variable interest rate can fluctuate and your credit card issuer doesn’t have to let you know when your variable rate is increasing. Variable interest rates are typically tied to another interest rate, most often the national prime rate as published by the Wall Street Journal. If your credit card has a variable interest rate it’s typically stated something like “16.74% plus prime.”

The purchase interest rate is the interest rate applied to purchases you make on your credit card. Depending on how you use your credit card, it may be the only interest rate you ever have to deal with.

The cash advance interest rate is the interest rate applied to cash advances – cash withdrawals made against your credit card balance. Cash advances don’t have a grace period and interest starts being added right away.

The balance transfer interest rate is the interest rate that’s applied to a balance transfer. You may receive a promotional balance transfer interest rate. These promotional rates are often low, i.e. less than 5%, and last anywhere from 3 months to 12 months.

The default or penalty interest rate is the interest rate you get charged for defaulting on your credit card terms. Default includes things like making a late credit card payment or going over your credit limit.

How payments are applied to balances with different interest rates

This is how things are done now:

When you have different balances with different interest rates on a single credit card, any payment above the minimum does toward the balance with the lowest interest rate. No payments are applied to the balances with higher interest rates, so they continue to accumulate finance charges until the lower interest rate balance is completely repaid.

How things will be next February:

New rules go into effect February 22, 2010 that will change the way payments are applied to balances with different interest rates. Card issuers will be required to put any payment above the minimum toward the balance with the higher interest rate. This saves you money in the long run.

What causes credit scores to go up?

Your credit score could rise for a number of reasons. It could be something you did or it could have been the credit card company’s way of trying to make more money.

You could cause your interest rate to increase because you:

• Paid late on your credit card
• Maxed out your credit card balance
• Wrote a bad check for your credit card payment
• Didn’t abide by the credit card terms
• Used your credit card illegally

What to do when interest rates go up

If your credit card interest rate goes up, the credit card issuer is required to give you at least 45 days advance notice. During that 45-day period, you have the right to reject the new credit card interest rate. If you reject the new rate, you’ll have the chance to pay off your balance at your older, lower interest. However, you’ll be required to close your credit card. Before you opt-out of the new rate, make sure you’re really ready to lose the credit card.

Credit card issuers don’t have to give advance notice if they’re increasing your interest rate because you defaulted on your credit card. If it’s your first late payment, your lender may be lenient and lower your interest rate. Otherwise, after six months of timely credit card payments contact your lender and request your old rate. Starting February 22, 2010, your lender has to lower your rate after six months of timely payments.

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