Over the years, credit card companies have developed several different methods for computing the balance on which credit card finance charges are calculated. Federal law requires creditors to state the Annual Percentage Rate (APR) when referring to interest and the method used to compute the unpaid balance on which interest is charged.
Below is a description of some methods for calculating the unpaid balance on a credit card and how different calculations affect finance charges. These calculations were made by faculty at the University of Illinois Cooperative Extension. The following methods are described:
* previous balance method
* adjusted balance method
* average daily balance method (excluding and including newly billed purchases)
* two-cycle average daily balance method (excluding and including newly billed purchases)
Suppose you receive a statement on July 1 with the following information:
Previous balance as of June 1 - $300
Payment (on June 15) - $200
Purchase (on June 15) - $100
The stated Annual Percentage Rate (APR) is 18 percent a year or 1.5 percent per month.
• Previous Balance Method: Using the previous balance method of computing interest, the creditor would charge you $4.50?1.5% or 0.015 times the previous balance of $300, or $4.50. Your $200 payment on June 15 is ignored.
• Adjusted Balance Method: Using the adjusted balance method, you would be charged $1.50?1.5% or 0.015 times the adjusted balance ($100), which is the previous balance ($300) minus payments made ($200). This is the best deal for consumers but rarely used by creditors.
• Average Daily Balance Method: The creditor may figure your average daily balance either including or excluding newly billed purchases (i.e., expenses incurred since the last credit card bill).
* Using the average daily balance method excluding newly billed purchases, the creditor would charge you $3.00?1.5% or 0.015 times the average daily balance, which was $300 for the first half of the month and $100 for the last half, for an average daily balance of $200.
* Using the average daily balance method including newly billed purchases, you would be charged $3.75?1.5% or 0.015 times the average daily balance, which was $300 for the first half of the month and $200 for the second half, or $250 overall. Using this method effectively eliminates the grace period on new purchases. The only way to have a no-interest grace period is by paying the outstanding balance in full each month.
• Two-Cycle Average Daily Balance Method: While the average daily balance method has been the most common method of calculating outstanding balances, the two-cycle average daily balance method has gained popularity with credit card issuers recently. With the two-cycle method, the average daily balance is calculated on the sum of the average daily balance for the previous and the current billing cycle. New purchases may or may not be included. This method is especially expensive for consumers who carry large balances.
* Using the above scenario, suppose the average daily balance for May was $153. The average daily balance for the month of June was $200. The only purchase in the month of May was for $37 on the 15th. Using the two-cycle average daily balance excluding new purchases, you would be charged the sum of the average daily balance for the previous month ($153) and the current billing cycle ($200), or $353. The creditor would charge you $5.29?1.5% of the two-month average daily balance of $353.
* Using the two-cycle average daily balance including new purchases, you would be charged the sum of the average daily balance for the previous month ($172: 153 + 37 = 190; 153 + 190 divided by 2 = 172) and the current billing cycle ($250). The creditor would charge you $6.33? 1.5% of the two-month average daily balance of $422. As you can see by this example, the finance charge for one month ranged from $1.50 to $6.33. Quite a difference!
Do you know how your credit card company calculates the balance on which interest is charged? Check your next credit card statement, or call your creditor(s) to determine their balance calculation method.
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