Credit card companies determine interest charges in a variety of ways. The method they use can be a huge factor in determing how much you pay over time! Unfortunately, many people make the costly mistake of not fully understanding how their interest is calculated. Let us show you the different types of calculation methods and which one’s will cost you the most:
Types of Calculations
For people who have to carry a credit card balance from month-to-month, it’s important to know how your finance charges are determined. There are several ways that credit card interest is calculated:
Average Daily Balance: This type of interest computation is the MOST COMMON. The issuer adds together what you owe at the end of each day in the billing cycle and then divides the total by the number of days in the period.
For example, if you had a consistent balance of $500 per day for the full 31 days in your billing cycle, your calculations would look like this: $500 x 31 / 31 days = $500.00 average daily balance. But if you had a balance of $500 for the first 15 days and $1000 for the last 16 days of the billing cycle, your calculations would look like this: $500 x 15 + $1000 x 16 / 31 days = $758.06 average daily balance. The credit card issuer would then take the average daily balance, multiply it by your APR, and then divide it by 12 (months). Points to consider:
- Average daily balance is the MOST COMMON form of calculating interest.
- If you make a large purchase at the beginning of the monthly cycle, you will end up paying a higher interest rate than if you made it torwards the end of the month.
- To make matters more confusing, many billing periods are not a month long and may not start at the beginning of the month nor end on the last day of the month.
- Potentially you could make a large purchase at the end of the month and have it show up at the beginning of your next billing cycle.
Adjusted Balance: This method determines interest by subtracting all payments from the previous billing balance. It does not factor in new charges! The rate applied to the balance is determined by using a base rate (such as the prime rate, 1, 3 or 6-month treasury bill rate or the Federal Reserve discount rate) and adding a percentage to this base. Other points to consider:
- THIS IS THE MOST FAVORABLE WAY TO CALCULATE INTEREST! Adjusted balance calculations result in the lowest interest charges since new purchases aren’t taken into account and all payments are deducted from your previous balance before interest is added.
Previous Balance: This type of interest calculation takes the outstanding balance at the end of the previous billing period and applies interest to that total. Charges in the current billing period are not included. The previous balance method results in more costly finance charges than the adjusted balance method because current payments (which would lower the loan balance and thus the finance charge) are not included in the calculation. But this method is usuallly less costly than average daily balance calculations. Points to consider:
- More costly than adjusted balance – but less costly than average daily balance.
Two Cycle Average Daily Balance: This calculation is less common and uses the average daily balance from the previous two billing cycles to calculate interest charges. The finance charges are based on the current and previous billing cycles, so a large average daily balance during either month will create higher interest charges.
For example, a cardholder with an average daily balance for the June, July, and August of $100, $1000, $100, will have interest calculated on $550 for July, which is only 55% of the expected interest of $1000. But in August, interest will be based on $550 again, which is 550% higher than the expected interest. Points to consider:
- Typically, the MOST EXPENSIVE way to calculate interest.
- If balances are paid in full each month, can work in consumers favor.
- This method of calculation is especially unfavorable if you carry a balance month-to-month. Many experts recommend avoiding cards using this calculation method completely.
Avoid Interest Altogether
Most credit card issuers offer a grace period between 20 and 25 days. A rare few provide up to 30 days! This is the time you have to pay in full before interest rates apply. Interest is only added when you carry a balance to the next billing period. So if you’re confused about how your interest is calculated, pay the bill in full each month. This way you avoid interest altogether!
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