Credit card issuers calculate finance charges each month on your outstanding account balance using a variety of methods. Some of these credit card providers use an approach called the previous balance method.
The Previous Balance Method Explained
The previous balance method of calculating your finance charges uses the balance at the beginning of the billing cycle to calculate your finance charge for that billing cycle. This means none of the activity that takes place with your account during that particular monthly billing cycle will affect your finance charge costs.
A benefit of the previous balance method is that any charges made to your account during the billing cycle won't lead to a higher finance charge. However, on the downside, payments you make during the billing cycle also won't reduce your balance and, consequently, your finance charges.
If your credit card issuer uses the previous balance method to calculate your finance charge, keep in mind that your balance carries over to the next billing cycle, so what you do this month affects your finance charge for next month.
The previous balance method can be more expensive than other types of finance charge calculation methods. If your credit card issuer uses this method, you can minimize the amount you pay in finance charges each month by paying more money to the account than the amount you charge during the month.
Finance Charge Example
The following shows an example of a finance charge calculated using the previous balance method.
APR (Annual Percentage Rate) = 14 percent
Periodic rate = 1.17 percent (APR / 12 months)
Days in billing cycle = 30
Beginning balance = $1,000
Payment made on 16th day = $100
Charge made on 20th day = $50
Ending balance = $950
Finance charge = Previous balance * periodic rate
= $1,000 * .0117
= $11.70 finance charge
Compared to the Average Daily Balance Method
Many credit card issuers use the average daily balance method to calculate finance charges. With this method, the credit card issuer totals your balance each day of the billing cycle, then calculates the average of that total.
If your credit card issuer used the average daily balance method, your finance charge with the same details as the scenario above would be slightly lower at $11.40, assuming you made payments and purchases on the same day of the billing cycle.
Find Out the Method Your Credit Card Issuer Uses
You can find out your credit card issuer's method for calculating finance charges by reading your credit card agreement or the back of your credit card statement. Look for a section called "How We Calculate Your Finance Charge." Contact your credit card issuer if you still have questions about your finance charge or its calculation.
If you choose to carry a balance on your credit card, look for a card that comes with a low APR. Ask which interest calculation method the company uses, and make your card choice based on your spending patterns and the interest-calculation method that most favors your spending and payment patterns.
You can avoid finance charges regardless of which method your credit card issuer uses by paying your credit card balance in full each month.