The finance charges you see on your credit card statement each month are based on the card's annual percentage rate. The lower your rate, the less interest you pay. Many people are not aware that issuers use several methods to calculate interest on credit cards. The method used for your card must be disclosed, but you might never have read the fine print that governs your account. You should, because the method your credit card provider uses can make a substantial difference in how much interest you pay.
Basic Interest Calculations
All credit card interest charges are based on a simple interest calculation. Suppose your credit card rate is 12 percent. One month's interest is 1/12 of that, or 1 percent. If you have a balance of $1,500, your interest charge for the month is 1 percent of $1,500 or $15. Each of the five methods of calculating interest on credit cards discussed here is a variation of this basic principle.
Average Daily Balance
The average-daily-balance method takes the ending balance of the previous billing cycle as its starting point. New charges are added on a proportional basis determined by how many days the charge is on the account. For instance, if you make a $50 charge halfway through the cycle (15 days), $25 (1/2 of that charge) is added to your ending balance to find your average balance. Then the simple-interest method is used to calculate interest charges.
The average-daily-balance method starts by dividing your annual interest rate by 365 (the number of days in a year). Then the balance of your account each day is multiplied by this daily rate. The amounts for each day in the billing cycle are totaled to determine your interest charges for that cycle.
The best methods of calculating interest on credit cards for the consumer are the previous-balance method and the adjusted-balance method. In the previous-balance method, interest is calculated for the current billing cycle using your ending balance from the previous cycle. Charges and payments that have been made during the billing cycle are not counted when calculating the interest.
The adjusted-balance method is the same, except payments made during the current billing cycle are deducted from the previous balance before interest is calculated.
By contrast, the two-cycle method is the most expensive for the consumer. This method starts with your ending balance from the previous cycle. The total of all new charges made during the cycle are added in, but payments are not subtracted. Your interest is calculated on this amount, so you might be paying interest on money you paid off weeks ago.
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