Interest rate calculation on credit cards

Question: How do credit cards calculate interest on purchases and what is the difference in the way interest is calculated? Bob, Coralville, IA

Answer: As you can imagine, it isn't easy. Credit card companies use different methods calculate the interest on your purchases. The method the credit card issuer uses to calculate what you owe has a big impact on how much you will pay.

The easiest way to avoid the whole issue is to pay off the balance in full at the end of the month.

One technique is the average daily balance, excluding new purchases. Each day, the bank totals up what you owe it, excluding new purchases. That sum is divided by the number of days in the billing cycle to calculate your average daily balance, and then a finance charge is imposed. This way of calculating your charges is favorable to you, but most credit card issuers include new purchases in the average daily balance calculation. Another common method is the "adjusted balance." The balance is the outstanding balance at the beginning of the billing cycle, minus payments and credits made during the billing cycle.

That said, the regulations that go with the new credit card law will make it much easier for your to look at your statement and understand the rate you're being charged, how long it will take you to eliminate the debt if you only make minimum payments, and what money you'd have to send to your card company to get rid of the debt in several years. You can learn more about the interest rate calculations, fees, and the new rules governing credit cards at the Federal Reserve's guide to credit cards. Online calculators like those at dinkytown.net and choosetosave.org make it easy to run the numbers.

There are several changes with credit cards that are worth highlighting since it affects the interest rate calculation. The changes are in your favor. First, if your credit card issuer raised your interest rate after the first year the new rate only applies to new charges. If you're carrying a balance the old interest rate still applies to that balance.

Second, if you make more than the minimum payment on your credit card bill the issuer has to put the extra money toward the balance with the highest interest rate.

And last, the two-cycle (double-cycle) billing has been banned. (It was an outrageous calculation, since it took the average daily balance for two billing cycles, the current one and the previous one, including new purchases. In essence, it eliminated the grace period for customers who carry a balance. The government finally woke up to the abuse.)

Again, none of this really matters if you pay off the bill every month.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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