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A finance charge is a broad term referring to any amount that you pay in order to borrow money. This may include interest charges and other fees that lenders charge, depending on the type of loan and your individual terms.

When it comes to credit cards, you’ll have to pay a finance charge if you fail to pay your balances in full and on time each month. Over time, those charges can add up, especially if you continually carry a balance on your card month-to-month.

Once you receive your statement each month, you will usually have a given period of time, or grace period, before the payment is due. Under the Credit CARD Act of 2009, this period must be at least 21 days, but many issuers offer 25-day grace periods.

What is a finance charge?

A finance charge is any cost you incur by borrowing money. For credit cards, finance charges include interest and other fees indicated in the cardholder agreement. These charges can vary based on computation methods.

How do credit card companies calculate finance charges?

When you apply for your credit card, your issuer should explicitly state in the terms and conditions exactly how finance charges are calculated. Calculations and rates may vary between issuers and even among cards under the same issuer.

Here are a few of the most common methods and how they’re calculated:

Average daily balance

Average daily balance is calculated by adding each day’s balance and then dividing the total by the number of days in the billing cycle. That number multiplied by one-twelfth your annual percentage rate, or APR, equals your monthly finance charge. This is considered the most common method. If your issuer uses this method, it can be beneficial to pay your balance throughout the month, lowering your daily balances.

Daily balance

Similarly to average daily balance, your issuer calculates the actual balance you carried each day of your billing cycle. Instead of taking the average, though, each day’s balance is multiplied by 1/365th of your APR to find the daily finance charge, then added together to total your finance charge for the billing cycle.

Two-cycle billing

A credit card computation method in which you are charged interest on two cycles of card balances rather than just the most recent. This method can result in interest charges on debts already paid and was outlawed under the Credit CARD Act of 2009.

Previous balance

Under this method, charges are based on the balance carried over from your previous billing cycle to the new one or the outstanding balance at the beginning of the billing cycle.

How to avoid finance charges

The best way to avoid finance charges is by paying your balances in full and on time each month.

As long as you pay your full balance within the grace period each month (that period between the end of your billing cycle and the payment due date), no interest will accrue on your balance. If, instead, you pay just the minimum amount due, you’ll find finance charges calculated into your next statement based on whichever method your issuer uses.

Other types of finance charges, like balance transfer fees, late fees and cash advance fees are difficult to avoid if you incur them, and they don’t have the same grace periods as interest charges. Consider whether taking on these charges is worth the benefits you’ll receive.

Similarly, if your card has a zero percent introductory APR promotional offer, make sure you read your terms to understand the finance charges you’ll take on if you haven’t paid your balance in full by the end of the introductory period, so you can avoid them when the time comes.