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Have you ever looked at your credit card statement’s finance charge and wondered, “Just how, exactly, did they come up with that?” Or perhaps you are card shopping and all those APR’s have made you go cross-eyed.
There actually are different ways a credit card company can calculate your finance charge. And it is important to understand how they make those calculations.
After all, the calculations directly affects your balance and minimum payments.
APR Calculation Methods
When you are comparing credit cards or making a decision as to debt consolidation, the APR is the most important detail you should look at.
Credit card companies may employ different ways to calculate and use that APR. The methods of calculation include “average daily balance”, “adjusted balance”, “previous balance” and the lesser known “two-cycle or double-cycle balance”.
How these calculations affect you is equally important.
Average Daily Balance
The “Average Daily Balance” is the most commonly used calculation and is based on the beginning balance each day of the billing cycle.
The card company takes the total balance each day minus any credits and adds them all together divided by the number of days in the billing cycle and then applies the APR based on that result.
The Two-Cycle or Double-Cycle method is the least favored method, especially by consumers who carry a balance on their cards. They normally offer lower APRS that look favorable; but are actually only favorable to those who pay off their balances each month.
This method uses the activity from the last two months’ billing cycles, which negates the interest free period that most cards offer (grace period).
Therefore, if you carry a balance or decide to make a minimum payment instead of paying off the balance you are actually penalized.
The wording on this specific computation may be misleading or hard to understand. For example, you may see “rolling consecutive twelve billing cycle period.”
If you notice this method being used or are having trouble understanding the verbiage, then your best bet would be to call the card issuer directly and have a customer service agent explain it to you before you commit to it.
Adjusted Balance Method
The “Adjusted Balance” method is the most beneficial method for cardholders. The balance is calculated by subtracting payments or credits made during the current billing cycle from the balance at the end of the previous cycle.
With this method, cardholders can avoid interest charges on current charges by making a payment before the end of the cycle.
Previous Balance Method
The “Previous Balance” method is similar in that it uses balances from the previous billing cycle. The difference is that it does not include payments, credits or purchases made during the current billing cycle.
The Difference is in the Results
The differences in the above methods may seem subtle, but really are not.
When considering the methods it can mean great variation in your finance charge amount. The Federal Trade Commission uses the explanation below:
“Suppose your monthly interest rate is 1.5 percent, your APR is 18 percent, and your previous balance is $400. On the 15th day of your billing cycle, the card issuer receives and posts your payment of $300. On the 18th day, you make a $50 purchase.
- Average Daily Balance method (including new purchases), your finance charge would be $4.05.
- Average Daily Balance method (excluding new purchases), your finance charge would be $3.75.
- Average Daily Balance Double Cycle method (including new purchase and the previous month’s balance), your finance charge would be $6.53.
- Adjusted Balance method, your finance charge would be $1.50.”
Of course, you should also take into account other APR’s as well.
If you are credit card shopping, you should review the interest rates in three different areas that will affect your finance charge. Look at the interest rate charged on normal purchases, the rate charged on balance transfers and the rate charged on cash advances.
Certain APR’s are determined by the way you choose to use your card.
Questions you will need to ask yourself are:
- “Will you be making many cash advances?”;
- “Are you planning on transferring balances to consolidate?” and
- “Will you carry a balance or pay-off the balance each month?”
Understanding the way a card company calculates the monthly finance charge is only half the battle.
Once you have chosen your card you should continue to review the terms included on each month’s statement to ensure that the terms have not changed. Some card companies reserve the right to make term changes without much if any notice.
The bottom line is that knowing your own spending and payment habits will assure that you make a wise financial decision.