Credit Card Finance Charges
Ever wonder how credit card companies make their money? If you’re like me, you probably have, and if you weren’t sure, they make the bulk of their money from finance charges.
“Finance charges” are fees tacked on to your existing balance if it isn’t paid off in full within the grace period, or before the next billing cycle.
These charges can range depending on your balance and the APR (interest rate) of your credit card. While they may not seem like much if you’ve got a small balance of say a few hundred dollars, they can certainly add up. And if you only make the minimum payment each month, chances are you won’t be doing much more than paying interest on your credit card, while leaving the principal balance untouched.
And the less you pay each month on an existing balance, the more you will pay in interest year after year.
The best way to avoid paying finance charges is to contact your bank and ask them exactly how they calculate finance charges, and when they apply them to your balance. Banks use different methods, so it’s imperative to speak directly with your credit card company to get the right information.
Some banks use the average daily balance method whereby they take your daily balance, divide it by the days in the month and then multiply it by the credit card APR divided by 12 (months).
For example, if your APR is 20% and your average daily balance is $500, your finance charge would be $8.33 a month, or nearly $100 a year. And that’s before factoring in compounding interest.
Another method for assessing finance charges is the two-cycle billing period which takes the sum of the last two months to determine applicable finance charges. But most banks using this method leave out new purchases, so the finance charge is similar to the average daily balance system.
All that said, the best practice aside from understanding how your bank assesses finance charges is to avoid paying them. If you have a large balance at a high APR, try a credit card balance transfer to a 0% APR credit card. That way you can avoid finance charges for up to 12 months and pay the card down substantially, paying principal only. This may even allow you to pay the credit card off completely without incurring any finance charges or associated fees.
And never make minimum payments on your credit cards unless you have to. This will result in the highest amount of finance charges, and a life full of debt.