Unfortunately, cardholders who don’t bother learning the definition of a finance charge leave themselves vulnerable to those very charges. The definition of a finance charge is, simply put, the interest you pay on a debt you owe. In terms of credit cards, if you carry a balance from one payment period to the next, you’ll be charged a finance charge — or interest — on that leftover balance.
- Finance Charge Definition
- Interest vs. Finance Charge
- How Credit Card Finance Charges Are Calculated
- Factors That Affect Finance Charges
- How To Avoid Paying Finance Charges
A credit card’s finance charge is the interest fee charged on revolving credit accounts. It is directly linked to a card’s annual percentage rate and is calculated based on the cardholder’s balance.
Most cardholders aren’t aware of finance charges until they purchase an item. When they allow a portion of their balance to carry over to the next month, the charge kicks in.
Finance charges act as a convenience charge of sorts — a penalty that the credit card company imposes for not forcing you to pay your balance in full every month. In short, as long as you carry a balance, you will face a finance charge.
Interest is a type of finance charge that cardholders must pay if they carry a balance on their credit cards. Finance charges may also include other transaction fees in addition to interest, including account maintenance fees and late fees in addition to interest. Interest rates vary between cardholders and card issuers, and finance charges vary accordingly.
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Unlike a mortgage or vehicle loan that has a predetermined repayment plan, credit card finance charges can change from month to month. The finance charge is generally calculated by dividing your APR by 365. Then, you multiply 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 throughout 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.
Several factors can affect the finance charges that consumers pay. The first — and arguably the most significant — is the interest rate. Individuals who qualify for the lowest interest rates pay less in finance charges than those who pay higher interest rates. By lowering their interest rates, consumers can lower their payments.
To qualify for the lowest interest rates, consumers must take action to improve their credit scores. They may need to pay down debt, create a budget so they pay bills on time and develop a habit of checking and correcting their credit reports regularly. Not only does this boost the credit score, but it also helps establish better financial practices.
Other factors that affect finance charges include when credit holders pay the bill and where they use their cards. Banks include late fees and foreign transaction fees in the finance charge. Missing a payment or paying for expenses while on an international vacation can increase the finance charge.
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To avoid paying finance charges, cardholders must first understand what actions incur a charge. Those who do not pay their balances in full each month always pay a finance charge for the privilege of carrying the debt. If it’s not possible to pay off the balance, cardholders may be able to take advantage of an offer to transfer balances to another card with a 0% APR promotion.
However, carrying a balance is not the only way to accrue a finance charge. Some card issuers charge fees for balance transfers, cash advances and purchases in foreign countries. Those who don’t want to pay these fees need to steer clear of the activities that trigger them. For example, a cardholder who frequently travels internationally may want to find a card that carries no foreign transaction fees.
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.
Click through to learn more about how to get the best credit card interest rates.
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This article has been updated with additional reporting since its original publication.