Understanding Credit Card Costs

Tips on Reducing Finance Charges

An illustrated fact sheet that explains how finance charges for credit cards are calculated, and shows how to reduce the cost of using credit cards. Includes a glossary of financial terms relating to credit cards.

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Note: Last revision 1996. Use this information as a general guide only; consult with a local consumer group for laws specific to your state.

Introduction

There are many ways to lower credit card costs: you can switch to a card with a lower interest rate, make sure you benefit from the card's grace period, and avoid special fees. This publication explains how finance charges are calculated and shows how to reduce the cost of credit.

Grace periods

Most credit cards allow you to pay off purchases without being charged interest, by taking advantage of their "grace period." This is an amount of time in which you can pay off a debt without incurring finance charges. It is usually about 25 days.

To make use of a grace period, pay your bills in full each month by the payment due date. If you owe any money on your previous statement (referred to as having an "outstanding" or "previous" balance), in most cases you will lose the benefit of having a grace period on new purchases for the current month.

Not all credit cards have a grace period. When you use a card with no grace period, the bank begins charging you interest on the day the purchase is made or the day it is recorded (posted) on your account, depending on the bank's policy. When a credit card does not have a grace period, there is no way to avoid paying interest on your purchases.

If you use a card that has a grace period (and you have no outstanding balance), you will not be charged interest until the next billing cycle, for purchases you make during the current billing cycle. In addition, you won't be charged any interest if you pay off your balance in full during the grace period of that cycle.

(However, you will probably be charged interest on cash advances every day until you repay them.)

THE BOTTOM LINE: If you have an outstanding balance at the beginning of the new billing cycle, you will not benefit at all from the grace period. Try to pay off your balance in full each month to maintain the grace period and avoid paying interest.

Cash advances

A cash advance is a loan billed to your credit card. You can obtain a cash advance with your credit card at a bank or an automated teller machine (ATM) or by using checks linked to your credit card account.

Most cards charge a special fee when a cash advance is taken out. The fee is based on a percentage of the amount borrowed, usually about 2% or 3%.

Some credit cards charge a minimum cash advance fee, as high as $5. You could get $20 in cash and be charged $5, a fee equal to 25% of the amount you borrowed.

Most cards do not have a grace period on cash advances. This means you pay interest every day until you repay the cash advance, even if you do not have an outstanding balance from the previous statement.

On some cards, the interest rate on cash advances is higher than the rate on purchases. Be sure you check the details on the contract sent to you by the card issuer.

Here is an example of charges that could be imposed for a $200 cash advance that you pay off when the bill arrives:

Cash Advance Fee = $4 (2% of $200)
Interest for one month = $3 (18% APR on $200)
Total cost for one month = $7 ($4 + $3)

In comparison, a $200 purchase on a card with a grace period could cost $0 if paid off promptly in full.

THE BOTTOM LINE: It is usually much more expensive to take out a cash advance than to charge a purchase to your credit card. Use cash advances only for real emergencies.

Costly fees

Many people look for a card that doesn't have an annual fee, but did you know that there are other fees that can cost you more in the long run?

Late fees. Most cards charge a fee when payments arrive late, after the due date. Some banks wait a few days before assessing this fee, but many impose it the day after the payment was due.
Some companies have a set fee, such as $10 or $15, while others charge a percentage, such as 5%, of the minimum payment due. Just paying late fees twice in one year can cost you more than an annual fee.
To avoid late fees, mail your payment in plenty of time to arrive before the due date. If you pay your bill at the bank's branch or ATM, find out how long it will take to process your payment. Sometimes payments made at a branch or ATM are not credited for a few days.
Over-credit-limit fees. Most cards assess a fee if you charge more than your credit limit. These fees are charged each time you exceed your limit, so you could be hit with several of them during one billing period.
Most banks have a set fee, such as $10 or $15, while others charge a percentage, such as 5%, of the amount you are over your limit.
If you charge $400 over your limit, with a 5% penalty, you will pay a fee of $20. This is in addition to interest charges.
Lost card replacement fees. A few companies charge people whose cards have been lost or stolen more than once or twice. These fees are usually $5 or $10.

THE BOTTOM LINE: Special fees can cost you a lot, so keep track of when you mail your payments and how much credit you have left.

Minimum monthly payment

The "minimum monthly payment" is the smallest amount you can pay and still be a cardholder in good standing. Banks often encourage you to make the minimum payment, such as 2% of your outstanding balance or $20, whichever is less. Some statements refer to the minimum as the "Cardholder Amount Due." (That is not the total amount you owe.)

If you only pay the minimum, it can take years to pay off the debt, and you will pay a lot more in interest. Suppose you owe $2,000 on a card with 19% interest and a 2% minimum payment. Paying just the minimum every month, it will take you 265 months--over 22 years--to pay off the debt, and it will cost you nearly $4,800 in interest payments.

Doubling the amount paid each month to 4% of the balance owed would allow you to shorten the payment time to 88 months from 265 months--or 7 years as opposed to 22 years--and save you about $3,680.

If you don't pay anything, or pay less than the minimum, you will be charged a late fee and will be subject to loss of your credit card. In addition, there may be a negative report to credit bureaus. That report could affect your ability to obtain credit in the future.

Some cards allow you to skip a payment without penalty. While this sounds like the bank is giving you a break, you will be charged interest during this period and will owe more in interest than you did before.

THE BOTTOM LINE: Making just the minimum payment is the most expensive way to pay off your balance. The more you pay each month, the shorter the time it will take you to pay off the debt and the less interest it will cost you.

Calculating interest

Most banks use an "average daily balance" method to calculate interest.

Average Daily Balance Method

Every day, the bank adds your charges and payments to learn what you owed it that day. It adds these totals and divides that figure by the number of days in the month, to determine your average daily balance.
Then the bank divides its annual interest rate by 12 (the number of months in the year) to get a "monthly periodic interest rate." For example, an 18% interest rate divided by 12 equals a monthly rate of 1.5%.
The bank multiplies your average daily balance by the monthly periodic interest rate, to obtain the finance charge for that month.

In calculating your daily balance, most banks include charges made during the month ("average daily balance, including new purchases"). Others exclude those charges until the next statement ("average daily balance, excluding new purchases"), which is to your benefit.

Two-Cycle Billing Method

Some banks retroactively eliminate the grace period by using a "two-cycle billing method." If you don't pay the entire balance, the finance charge is based on the sum of the average daily balances for both the previous and current months. (Some banks exclude new purchases from the finance charge calculation of their two-cycle billing method.)

You are only charged for a two-month time period in the first month you don't pay all charges. People who sometimes pay in full and sometimes leave a balance will pay about the same amount under the two-cycle method as with a "no grace period" card.

THE BOTTOM LINE: You should know how your bank calculates finance charges.

Understanding terms

The key to reading your credit card statement is to understand the terms on it. Here are explanations of common terms:

Amount due: Some cards use this term to describe the minimum monthly payment. This is not the total you owe on the card.
Annual percentage rate (APR): This is the finance charge, expressed as an annual figure, such as 16%.
Cash advance: A loan in the form of cash (as opposed to purchases of goods or services) made through a credit card.
Due date: The date by which your payment must be received by the company, for you to remain in good standing.
Finance charge: The interest charge on your outstanding credit card balance.
Grace period: A period in which you can make new purchases without paying interest. (Not all cards have a grace period.)
Late fee: A charge assessed if your payment is recorded after the due date.
Minimum monthly payment: The smallest amount you can pay to avoid being delinquent. Paying the minimum is the most expensive way to handle your credit card bills.
Monthly periodic rate: A fraction of the APR (1/12), the rate at which interest is assessed during the billing period.
New Balance: The total owed after new charges and credits have been added up.
Over-credit-limit fee: A charge assessed if you put charges on your credit card that exceed your approved credit limit.
Previous (or outstanding) balance: The amount you owed last month, after that month's payments and charges were added up.
Transaction fee: A charge for making a purchase or receiving a cash advance.

Tips to lower costs

Switch to a lower-rate card. Maintaining a $1,000 average balance on your 18% credit card will cost you more than $180 in interest over one year. If you switch that money to a 14% rate card you will save about $40. (Some banks reduce the interest rate on balances transferred from another issuer.)
Take advantage of your grace period. With a grace period, you won't be charged interest until the start of the next period, so try to pay off the entire balance each month.
Ask your bank if you can get a lower interest rate. Many banks have lower-rate cards. If you can't get a better rate from your bank, shop around for another card.
Always pay more than the minimum balance. Paying the minimum prolongs the time it will take you to pay off your balance, and costs you a lot more in interest.
If you are paying interest, mail your check as soon as you receive your statement. The earlier your money is received, the lower your average daily balance will be, reducing the amount you pay in interest.
Use savings to pay credit card bills. If you have $100 in a savings account at 3% interest, you will earn a little over $3 in one year. That $100, used to pay off $100 on an 18% card will save you $18, six times the interest you would have earned in your account.

Published / Reviewed Date

Published: December 27, 1996

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Credit ♦ Credit Cards ♦