Financial Literacy Series: What is a Credit Card Finance Charge?

Posted in Credit Card Rates , Financial Literacy • April 26, 2012

Credit cards come with a number of rates and fees that cardholders should be aware of; at the top of the list is the finance charge. It is one of the most common charges associated with every credit card, but many cardholders don’t know what it is or how it impacts the amount they pay each month.

Defining the Finance Charge

A credit card’s finance charge is defined as the interest fee charged on revolving credit accounts. It is directly linked to a credit card’s annual percentage rate (APR) and is calculated based on the cardholder’s balance.

Most cardholders aren’t aware of finance charges until they purchase an item, then allow a portion of their balance to carry over to the next month. It is at this point that the charge kicks in.

Finance charges were created as a convenience charge of sorts — a penalty the credit card company is imposing for not forcing you to pay your balance in full every month. This means, as long as you carry a balance, you will face a finance charge.

How Credit Card Finance Charges are Calculated

The finance charge is generally calculated by dividing your APR by 12 (for the number of months in your billing cycle) then multiplying the resulting credit card rate by your outstanding balance. Unfortunately, this is where the generalities stop.

Depending on the company, your finance charge could be calculated using one of the following methods:

• Average daily balance: The most common method used is the daily balance. It takes the average of your balance during the billing cycle, adding each day’s balance together and dividing by the number of days in the billing cycle.
• Daily balance: The daily balance method uses the credit card balance from each day of your billing cycle, then multiplies each day’s balance by the daily rate. Afterward, all of the days are added together to get your charge.
• Ending balance: The ending balance method takes your beginning balance and subtracts payments plus charges made during the billing cycle.
• Previous balance: The previous balance method pulls your balance at the beginning of the billing cycle — which is the same as the ending balance of the last billing cycle — but charges and payments during the billing cycle do not affect the finance charge calculation.
• Adjusted balance: This method uses the balance you carry at the beginning of the billing cycle, then subtracts any payments you make throughout the month.  This calculation method is typically the least expensive for cardholders.

When reviewing your credit card billing statement, the finance charge is something you want to take a close look at to ensure you’re being charged properly for any outstanding balance. Examining this charge also helps you determine how much extra you’ll need to pay to eventually eliminate your credit card debt.

This article is part of the Go Banking Rates Financial Literacy Movement, helping Americans get smarter and grow richer. Take our credit card quiz to test how knowledgeable you are!

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