Revolving Credit Making Your Head Spin?

By Jill Terry

You’ve shopped around and found a credit card with a great low rate. Unfortunately, depending on how the credit card company or bank calculates its finance charges, you may not be saving as much as you think.

There are at least four different ways of calculating a finance charge, with lots of variations on those methods, so a rate of 5% at one bank may translate to a different monthly figure than 5% at another bank. If you can’t find the balance computation method on the literature included with your application or new account materials, be sure to ask someone (call the toll free number that’s usually part of the package–and be willing to wait out transfers until you reach someone with enough training to know what you’re looking for).

Here’s a quick primer on how these calculations are made and what they mean to your budget. (To bring each method to life, we’ll plug in the same scenario into each method so you can see how the calculation might actually affect you: The bank says that in the month of May, your average daily balance was $100. On June 1, day one of the new billing cycle, your balance is $175. On June 10, you make a payment of $65 and on June 15, you make a purchase of $50, ending up with a balance of $160.)

• Method 1:
  Average daily balance (including new purchases):This balance is figured by adding the outstanding balance (including new purchases and deducting payments and credits) for each day in the billing cycle and then dividing by the number of days in the billing cycle.

  Balance was:
  $175 for 10 days ($175 x 10 = $1750)
  $110 for 5 days ($110 x 5 = $550)
  $160 for 15 days ($160 x 15 = $2400)
  $1750 + $550 + $2400 = $4700 divided by 30 days is $156.67.
  Finance charge rate would be applied to $156.67.

  Bottom line: New purchases are immediately part of the balance used to calculate the finance charge. Unless you’re using the card only as a balance transfer vehicle and never intend to make any purchases, this method is not ideal (but it’s better than many!).

• Method 2:
  Average daily balance (excluding new purchases): This balance is figured by adding the outstanding balance (excluding new purchases and deducting payments and credits) for each day in the billing cycle, and then dividing by the number of days in the billing cycle.

  Balance was:
  $175 for 10 days ($175 x 10 = $1750)
  $110 for 20 days ($110 x 20 = $2200)
  $1750 + $2200 = $3950 divided by 30 days is $131.67.
  Finance charge rate would be applied to $131.67.

  Bottom line: The clear winner. New purchases are not figured into the average daily balance so you get a little free ride time on what you buy.

• Method 3:
  Two-cycle average daily balance (including new purchases): This balance is the sum of the average daily balances for two billing cycles. The first balance is for the current billing cycle and is figured by adding the outstanding balance (including new purchases and deducting payments and credits) for each day in the billing cycle and then dividing by the number of days in the billing cycle. The second balance is for the preceding billing cycle.

  June balance was:
  $175 for 10 days ($175 x 10 = $1750)
  $110 for 5 days ($110 x 5 = $550)
  $160 for 15 days ($160 x 15 = $2400)
  $1750 + $550 + $2400 = $4700 divided by 30 days is $156.67.
  Finance charge rate would be applied to $156.67 for month of June and $100 for month of May = $256.67.

  Bottom line: This method is a nice double-whammy for anybody who regularly uses a credit card for purchases and carries a balance from month to month. You effectively pay for activity twice because the calculation method considers the current and previous month’s average daily balances. Unless you pay off your balance every month, steer clear of this method.

• Method 4:
  Two-cycle average daily balance (excluding new purchases): This balance is the sum of the average daily balances for two billing cycles. The first balance is for the current billing cycle, and is figured by adding the outstanding balance (excluding new purchases and deducting payments and credits) for each day in the billing cycle and then dividing by the number of days in the billing cycle. The second balance is for the preceding billing cycle.

  June balance was:
  $175 for 10 days ($175 x 10 = $1750)
  $110 for 20 days ($110 x 20 = $2200)
  $1750 + $2200 = $3950 divided by 30 days is $131.67.
  Finance charge rate would be applied to $131.67 for month of June and $100 for month of May = $231.67.

  Bottom line: While not as gouging as Method 3, Method 4 is still not a good deal for anybody who doesn’t pay balances in full each month because it counts each month’s activity twice.

Final note: Beware of minimum finance charges. Sometimes these so-called “minimums” are actually higher than what you’d pay if calculations were based only on your balance. If you tend to run high balances, this may not be an issue for you, but if you use your card moderately or rarely (yet still carry a balance), minimum finance charges will drive up your monthly payment unnecessarily. Your disclosures should tell you if minimum finance charges are imposed.