A finance charge is the cost you pay for borrowing money and is calculated based on an annual percentage rate of interest (APR). The basic method of computing finance charges is the same whether you are talking about a line of credit or a fixed-term loan. However, there are many variations. Which one is used to calculate finance charges can make a big difference in the cost of borrowing.
Finance Charge Basics
The simplest method of calculating finance charges starts by dividing the APR by the number of billing cycles per year (usually 12) to get a monthly periodic interest rate. For example, if you have an APR of 15 percent on a debt, the monthly periodic rate is 15/12, or 1.25 percent. Then the principal owed is multiplied by the periodic rate to calculate finance charges. When you make a payment, part of it goes to pay the finance charges and the money left over is applied to reduce the balance in the account.
Credit Card Finance Charges
Although credit card issuers use the basic methods to calculate finance charges described above, they employ several methods to determine the balance used for the computation. A common method is to find the average balance in your account, starting with your previous balance and adding/subtracting new charges and payments. Then the average balance is multiplied by the periodic rate to find the finance charge.
Another approach is the average daily balance method. Here, the APR is divided by 365 to find a daily periodic rate. The balance owed each day is multiplied by the daily periodic rate to find the finance charges for that day. Daily charges are totaled at the end of the billing cycle to find the total finance charges.
Two other methods of calculating finance charges sometimes used for credit cards are the adjusted balance and two-cycle methods. In the adjusted balance method, your starting balance minus any payments is used to calculate the finance charge. Purchases are only added to your balance afterward. The two-cycle method is just the opposite. Purchases are added to the starting balance and then your finance charges are figured. Payments are only credited afterward.
When you amortize a debt you pay it off gradually in installments (a car loan or mortgage, for example). Calculating interest charges for amortized debt uses the same principles described above.. However, unlike credit cards and other lines of credit, new debt is not added. Each month, your balance is less than the month before because part of the previous payment went to reduce the balance owed. Consequently your finance charge each month is less. By the time you near the payoff debt, almost all of your payment goes toward paying off what you owe and very little to finance charges.
Setting up an amortized payment schedule requires a financial calculator. This is because several variables (interest rate, number of installments and amount borrowed) have to be simultaneously calculated. There are free calculators you can use for calculating finance charges of this type.