My Debt Quest

For most of us who carry any kind of debt, finance charges are a regular part of our lives. We pay finance charges on our homes, our cars, our schooling, our credit cards, and whatever other parts of our lives we've found that we can put on credit. Our lenders are more than happy to calculate the finance charges for us, but knowing how those charges are calculated may motivate you to pay down that debt. Since they tend to have the highest interest rates, and therefore the most expensive finance charges, I am going to focus on how Credit Cards do their calculations:

Average Daily Balance

The most popular method of calculating credit card interest is the Average Daily Balance method. To calculate the finance charge, they add the balances from the end of each day of the billing cycle together and divide by the number of days in the billing cycle. This Average Daily Balance is them multiplied by either the daily periodic rate times the number of days in the billing cycle or by the monthly periodic rate.

Two-Cycle Average Daily Balance

Two-Cycle Average Daily Balance uses the same principles as the Average Daily Balance but they add the balances from the end of each day of the last two billing cycles and divide by the number of days in both billing cycles. If you do not carry a balance on your credit cards, there is no change in the amount of interest you will pay. If you are actively running your balance up, you will actually pay less interest. However, if you are paying off your cards, the Two-Cycle Average Daily Balance will cost you more in finance charges.

A Sample Calculation

Lets assume I have a credit card with an Annual Percentage Rate (APR) of 14.99%. For the sake of simplicity, we'll say the billing cycle starts on the first of the month and runs through the end of the month.

First, we'll figure out the Daily Periodic Rate, the amount of interest that the bank charges every day.

The Annual Percentage Rate is 14.99%. If we divide that by 365 days, we get the Daily Periodic Rate as 0.0410684% (we'll round that to 0.04107%). The bank will charge 0.04107% on the balance every day.

To calculate the Average Daily Balance, we need to determine the actual balance at the end of each day of the billing cycle. The bank gets the balance at the end of each day by taking the balance at the beginning of the day, adding any new purchases, and subtracting any payments (seems to go without saying, but if they can put it in their fine print, I can put it here).

We'll start our first month with a $1,000.00 balance and make no purchases or payments for the full 30 days of the month.

The daily balance for each day was $1,000.00. Adding together all of the daily balances we get $30,000.00, divide by the number of days in the billing cycle, 30, and we get the Average Daily Balance of $1,000.00.

Next, we multiply the Average Daily Balance, $1,000.00, by the Daily Periodic Rate, 0.04107% or 0.0004107, to get the Daily Finance Charge of $0.4107, multiply by the number of days in the billing cycle, 30, to get the Finance Charge of $12.32. The new balance on the credit card after one month is $1,012.32.

Now we'll look at a second month. In this month, we don't do anything for the first 10 days of the cycle. On day 11, we make a $300 purchase. Later in the month, we make a $100 payment on day 16 and another $200 purchase on day 21. The billing cycle closes at the end of day 30 again.

This Average Daily Balance will be a little more complicated. The daily balances are:
Days 1-10 (10 Days) - $1,012.32
Days 11-15 (5 Days) - $1,312.32
Days 16-20 (5 Days) - $1,212.32
Days 21-30 (10 Days) - $1,412.32

When we add the daily balances, we get $36,869.60. Divide this by the number of days in the billing cycle, 30, and we get the Average Daily Balance of $1,228.99.

We'll multiply the Average Daily Balance, $1,228.99, by the Daily Periodic Rate, 0.04107% or 0.0004107, to get the daily finance charge of $0.50, multiplied by the number of days in the billing cycle, 30, for the monthly Finance Charge of $15.14.

What happens if we make that $100 payment earlier in the month, on day 1?

The daily balances are:
Days 1-10 (10 Days) - $912.32
Days 11-20 (10 Days) - $1,212.32
Days 21-30 (10 Days) - $1,412.32

When we add the daily balances, we get $35,369.60. Divide this by the number of days in the billing cycle, 30, and we get the Average Daily Balance of $1,178.99.

We'll multiply the Average Daily Balance, $1,178.99, by the Daily Periodic Rate, 0.04107% or 0.0004107, to get the daily finance charge of $0.48, multiplied by the number of days in the billing cycle, 30, for the monthly Finance Charge of $14.53.

By making the same $100.00 payment at the beginning of the billing cycle instead of at day 16, we reduced the finance charge from $15.14 to $14.53. Over time, that small savings each month will add up.

What impact does Two-Cycle Average Daily Balance have on the finance charge?

In our example, the daily balances for both billing cycles are:
Days 1-30 (30 days) - $1,000.00
Days 31-40 (10 days) - $912.32
Days 41-50 (10 days) - $1,212.32
Days 51-60 (10 days) - $1,412.32

Adding up the daily balances gives $65,369.60, divide by the number of days in the two billing cycles, 60, and we get the Two-Cycle Average Daily Balance of $1,089.49. We'll multiply that by the daily periodic rate, 0.04107% or 0.0004107, to get the daily finance charge of $0.45, or $13.42 for the month.

Using the two-cycle average daily balance in this case, with an increasing balance, was to our advantage - $13.42 instead of $14.53. What happens if we were to pay off the full $1,000.00 on the first day of the new month, though?

Under the standard Average Daily Balance method, we would have to pay the $12.32 finance charge from the first month's balance, but otherwise would have a zero balance for the rest of the month, and no new finance charge.

With the two-cycle average daily balance, though, we would have 30 days with a daily balance of $1,000 and 30 days with a daily balance of $0.00, or a two-cycle average daily balance of $500, resulting in a monthly finance charge for the second month of $6.16.

As we pay down our balance, the two-cycle average daily balance will end up costing more in finance charges.

Conclusions

Calculating interest in credit cards is not necessarily something anyone needs to know. The credit card companies take care of all the calculations for us and post them right to our monthly statements. Understanding how the calculations work, though, may save you money in the long run.

(1) If you are paying down your credit card balances on a card that uses two-cycle average daily balance, you might consider transferring your balance to a card that uses the standard average daily balance method. The benefits of this transfer will depend on your starting balance and how quickly you make payments.

(2) If you can make your payment earlier in the billing cycle, the small savings in the finance charge each month will add up. Making payments earlier in the month and making multiple payments as soon as the funds are available will both impact your finance charge over the long haul.