Your credit card balance determines how much you will pay in interest each month. The higher the balance, the more interest you will pay. But credit card companies use different methods for calculating your balance -- some of those methods result in higher balances than others. For this reason, it's important to understand, at the outset, what type of balance calculation method your credit card company will use. The method, along with the interest rate, will dictate how much interest you pay if you carry a balance each month.
(For more articles on important credit card terms and what to look for when choosing a credit card, see Choosing and Using Credit and Debt Cards.)
Credit Card Balance Calculations
A credit card offer must explain how the company will calculate the balance on which it applies the interest rate (which is actually the annual percentage rate or APR). Each month, the credit card company applies the APR to the balance to compute the finance charge for that month (see Understanding Credit Card APRs) and may include or exclude new purchases in the balance. Excluding new purchases is better for a consumer because the balance will be lower. A lower balance means the amount of interest you pay will also be lower.
The balance is usually calculated in one of the following ways:
Daily Balance Method
This is the most common method. The company takes the beginning balance for each day and adds new purchases and subtracts payments made. The company calculates the finance charge for each day’s balance, then adds those figures together to get the finance charge for the whole billing cycle.
Adjusted Balance Method
This method is best for consumers. The credit card company computes the balance by taking the amount you owed at the start of the billing cycle and subtracting any payments made during the cycle. New purchases are not included.
Previous Balance Method
The company uses the amount you owed at the beginning of the billing cycle to compute the finance charge. It doesn’t take into account payments you made during the billing cycle.
Average Daily Balance Method (Including or Excluding New Purchases)
The company adds your balances for each day in the billing cycle and then divides that total by the number of days in the cycle. Payments made during the period are subtracted to get the daily amounts you owe. New purchases may or may not be included, depending on the plan. Plans that don’t add in new purchases are better for consumers.
If you are struggling with credit card debt, visit our Managing Credit Card Debt topic area.
Part of this article was excerpted from Nolo’s Credit Repair, by Margaret Reiter and Robin Leonard (Nolo).