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Where do finance charges come from?

Sure, you pay the finance charge on your bill, but do you understand how the credit card company arrives at the number?

Check out four of the most common calculation methods. But be warned: the method alone only tells part of the story. To make sure you're getting the best deal on a card, ask how the company calculates the charges and whether interest is calculated on a daily or monthly basis. Find out if there is a grace period for new purchases. And have the company rep explain when and how your monthly payments are applied.

Here are the calculation methods you're most likely to see:

Average daily balance: The company averages your daily balance. For instance, if you charged $100 on the first day of June and charged an additional $200 on the 16th, your average daily balance would be $200. That number times roughly one-twelfth your annual percentage rate (APR) equals your monthly finance charge. Interest may be calculated on a daily or monthly basis.

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Daily balance: The company calculates the actual balance you carried each day of your billing cycle and multiplies it by roughly 1/365th of your APR and adds it together.

Two-cycle balance: Similar to an average daily balance except that the daily average is based on your last two billing months, not just one. With this method, if you don't pay off your card in full one month, you'll be hit with retroactive interest on your next bill.

Previous balance: The bill will show beginning balance and ending balance for your account. The finance charge is based on the outstanding balance at the beginning of the billing cycle.

Source: The Federal Reserve

-- Posted: Jan. 9, 2003

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