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Calculating Credit Card Interests

When you are shopping for the best credit cards, it is important to consider the way the finance charges are calculated. There are several different calculating methods used by credit card companies. A few of these are; the average daily balance method, the adjusted balance method, and the previous balance method. Depending on which method is used can make a big difference in the amount of finance charges you pay on your credit card and can be an important consideration in choosing the best card for you.

Balance Computation Method for the Finance Charge

  • Average Daily Balance Method (including or excluding new purchases)
    Generally this is the method most companies use. It is based on your day to day balance. The company adds in your purchases or charges and subtracts payments and credits then figures out the charge. At the end of your billing period they figure your daily average and multiply that by your interest rate and this becomes your finance charge.

    Some cards have a grace period for new purchases and may not be added in for 25-30 days if you pay your card in full every month then these do not add additional charges.

    Cash advances are usually added in immediately.
  • Adjusted Balance Method
    This method is a little simpler and actually saves you money on finance charges. Instead of being a daily rate, this takes your balance and subtracts credits and payments during the period from your balance at the end of the previous statement. New purchases are not added in. Some companies don’t add unpaid finance charges to the balance either.
  • Previous Balance Method
    This method simply takes the balance from the last bill and calculates finance charges from there. While this means you are still getting charged for an extra month it also means you don’t get charged for 30 days for new purchases

    Then the bank divides its annual interest rate by 12 (the number of months in the year) to get a "monthly periodic interest rate." For example, an 18% interest rate divided by 12 equals a monthly rate of 1.5%.

The bank multiplies your average daily balance by the monthly periodic interest rate, to obtain the finance charge for that month.

  Average Daily Balance
(including new purchases)
Average Daily Balance
(excluding new purchases)
Adjusted Balance Previous Balance
APR 18% 18% 18% 18%
Monthly rate 1.5% 1.5% 1.5% 1.5%
Previous Balance $500 $500 $500 $500
Payments $400
on 15th day
(new balance = $100)
on 15th day
(new balance = $100)
on 15th day
(new balance = $100)
on 15th day
(new balance = $100)
New Purchases $100
on 20th day
on 20th day
on 20th day
on 20th day
Average Daily Balance $316.67 * $300.00 ** n/a n/a
Finance Charge $4.75 (1.5% x $316.67) $4.50 (1.5% x $250) $1.50(1.5% x $100) $7.50 (1.5% x $500)

* Average daily balance (including new purchases):
{($500 x 15 days) + ($100 x5 days) + ($150 x 10 days)}/ 30 days = $316.67

** Average daily balance (excluding new purchases):
{($500 x 15 days) + ($100 x 15 days)}/ 30 days = $300.00

In this example you can see that the finance charges for the month range from $1.50 to $7.50. based upon the method used. It should be obvious that If you carry a large balance, the method could make a tremendous difference in the interest you pay over a period.

Fixed and Variable Rate

  • Fixed Rate
    A fixed rate plan is one that doesn’t change with the fluctuations of the federal interest rate. This way you don’t have to guess about your rate from month to month. If you have a fixed rate, the Truth in Lending Act requires the lender to provide at least 15 days notice before raising the rate. In some states, there are laws that require more notice.
  • Variable Rate
    The interest on a variable rate card can change as the prime lending rate changes.. More frequently credit card companies set rates that vary with some interest-rate index. This could be the market rates on three-year U.S. Treasury bills or the prime rate charged by banks on short-term business loans. Card issuers must disclose, in their offers to you, that the rate may vary and how the rate is determined. This may be done by showing the index and the spread. The spread is the number of percentage points added to the index to determine the rate you will pay.

Credit card companies offer variable-rate, fixed-rate, and tiered-rate plans. For variable-rate credit card plans, the interest rate is calculated according to a formula. Three of the most commonly used formulas are:

  • Variable rate = Index + Margin
  • Variable rate = Index x Multiple
  • Variable rate = (Index + Margin) x Multiple

Credit card companies use several specific indexes to determine the rate of interest that they will charge. These are; the prime rate, the one-, three- and six-month Treasury bill rates, the federal funds rate, and the Federal Reserve discount rate. Most of these indexes can be found in the news paper or online. When the interest rates change so will your rates on credit cards unless you have a fixed rate card

The “margin” is a number of percentage points chosen by the credit card issuer. The card issuer also chooses the multiple.

The interest rate on a fixed-rate credit card plan, though not exactly tied to changes in another interest rate, also can change over time. Your credit card company must notify of any changes to you fixed rate. The card issuer must notify you before the "fixed" interest rate is changed.

A tiered interest rate means that different rates apply to different levels of the outstanding balance (for example, 16% on balances of $1 - $500; 17% on balances above $500).

A really good reason to make your payments on time is many companies will raise your interest rates if you are late with payments. You could go from 10% to 28% if you are not careful. The card companies must notify you if the intend to do this.

Some Credit card companies will charge different rate for different transactions. Goods and services might have one specific rate, cash advances another and transfer still a third.

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