Key Takeaways
- A finance charge includes interest rates, origination fees, service fees, and late fees.
- Credit cards calculate finance charges using different methods, often making it confusing for consumers.
- The average daily balance method calculates finance charges on the average balance over a billing cycle.
- Understanding your credit card’s method can help minimize or avoid high finance charges.
What Is Total Finance Charge?
A finance charge includes all costs of borrowing, interest and fees, and knowing how it works is important for managing credit. It’s particularly relevant to credit cards, where charges apply when you carry a balance. Many issuers use the average daily balance method to calculate these costs, and understanding it can help you minimize expenses and avoid debt.
Understanding How Total Finance Charges Are Calculated
At the end of each billing cycle on your credit card, if you do not pay the statement balance in full from the previous billing cycle’s statement, you will be charged interest on the unpaid balance, as well as any late fees if they were incurred. Your finance charge on a credit card is based on your interest rate for the types of transactions you’re carrying a balance on. These include purchases, balance transfers, and cash advances, each of which might have a different interest rate, and therefore a different amount you owe in each of those categories. Your total finance charge gets added to all the purchases you make—and the grand total, plus any fees, is your monthly credit card bill.
Credit card companies calculate finance charges in different ways that many consumers may find confusing. A common method is the average daily balance method, which is calculated as (average daily balance × annual percentage rate × number of days in the billing cycle) ÷ 365.
To calculate your average daily balance, you need to look at your credit card statement and see what your balance was at the end of each day. (If your credit card statement doesn’t show what your balance was at the end of each day, you’ll have to calculate those amounts as well.) Add these numbers, then divide by the number of days in your billing cycle.
The hardest thing to figure out is what your average daily balance was during the billing cycle.
Practical Example: Calculating Your Total Finance Charge
Wondering how to calculate a finance charge? To provide an oversimplified example, suppose your daily balances were as follows in a five-day billing cycle, and all your transactions are purchases:
Day 1: $1,000
Day 2: $1,050
Day 3: $1,100
Day 4: $1,125
Day 5: $1,200
Total: $5,475
Divide this total by 5 to get your average daily balance of $1,095.
The next step in calculating your total finance charge is to check your credit card statement for your interest rate on purchases. Let’s say your purchase APR is 19.99%, which we’ll round to 20% (or 0.20) for simplicity’s sake. Now you have all the inputs you need to do the calculation.
($1,095 × 0.20 × 5) ÷ 365 = $3 = Total finance charge
Your total finance charge to borrow an average of $1,095 for 5 days is $3. That doesn’t sound so bad, but if you carried a similar balance for the entire year, you’d pay about $219 in interest (20% of $1,095). That’s a high cost to borrow a small amount of money.
On your credit card statement, the total finance charge may be listed as “interest charge” or “finance charge.” The average daily balance is just one of the calculation methods used. There are others, such as the adjusted balance, the daily balance, the double billing balance, the ending balance, and the previous balance. You can avoid paying high finance charges if you know what method is used and pay your credit card bill in a way that minimizes or eliminates these charges.
The Bottom Line
The total finance charge is the full cost of carrying credit card debt, including interest and fees, often calculated with methods like the average daily balance. For instance, issuers may apply a daily rate to each day’s balance and add the results. Paying in full or reducing your balance can help you keep these charges low.