How are Credit Card Finance Charges Calculated?

There are a number of ways in which credit card finance charges are calculated including adjusted balance, average daily balance, two-cycle average daily balance, previous balance, and ending balance. Not all methods of calculation are created equal, and the focus is on the cardholder to understand how finance charges accrue on his or her account. This is made easier because every credit card company reveals its method of calculation before issuing a card.

Two basic methods for calculating finance charges

The basic formula for calculating credit card finance charges involves two methods. In the first, a periodic interest rate is determined by dividing the credit card's APR by 12 (the number of billing periods in a year). In the second, the account balance is multiplied by the periodic interest rate, and the resulting amount is the finance charge for that month. The only variable between methods is the way in which the account balance is calculated.

The average daily balance is calculated by taking the sum of each day's balance and dividing that by the total number of days in the billing period. So, in a month-long billing period, the average daily balance would be calculated by adding 30 individual daily balances plus the interest assessed each day, then dividing that amount by 30.

Choosing a credit card based on how finance charge are calculated

How a credit card company calculates its finance charges has a huge impact on the desirability of the card. A card with a low annual percentage rate (APR) may still end up with higher finance charges if the credit card company does not allow a grace period on new purchases. For example, the average daily balance method of finance charge calculation doesn’t always allow a grace period which means that finance charges begin to accrue as soon as each new purchase posts to your account.

Finding information on how credit card finance charges are calculated

For more detailed information on how a credit card company calculates finance charges, be sure to review the terms and conditions portion of a credit card offer and application. In general, the adjusted balance method is the best for customers, as it allows for a grace period and does not include new purchases from that month's billing period in the balance.