How is the interest rate one of the biggest factors in calculating finance charges of credit cards?

With a car loan or a mortgage, you borrow a set amount of money all at once and pay it back according to an annual interest rate. The amount you owe each month is the same. Credit cards have interest rates, too, but they also have to account for the fact that you can use that credit at any time over a single month. Therefore, the finance charges on credit cards are calculated in a different way than installment loans like car loans or mortgages. Credit card companies have a few ways of addressing this kind of debt. Some methods are straightforward, while others are more complicated. Each method results in a different finance charge on your bill. For this reason, you should make sure you understand how interest is calculated on a credit card before you apply or agree to its terms. Credit card companies use one of four calculation methods: previous balance, adjusted balance, ending balance, or adjusted daily balance. Previous and Adjusted Balance MethodsLet’s say that at the end of April you have a $300 balance on your credit card. Your bill is due May 1. If you do not pay anything toward that balance, on June 1 you will be assessed interest on that amount. The most straightforward way of calculating interest is just to apply the credit card’s APR (divided by 12) to the $300, known as the previous balance method. If your APR is 12 percent, then 1 percent will be applied to $300, and your finance charge will be $3.Another calculation method is to your benefit. Let’s say your balance at the end of April is, again, $300. On May 1, you make a payment of $150, resulting in a new balance of $150. According to the adjusted balance method, on June 1, you will be charged 1 percent on the $150, leading to a $1.50 finance charge. If you were being charged according to the previous balance method, you would still pay $3 in finance charges even though you made the $150 payment. Ending Balance MethodThere is also an ending balance method. It is like the adjusted balance method, but it also includes any purchases you may have made during the preceding month. Let’s say you have a $300 monthly balance at the end of April, and sometime in May, you make a payment of $150 but you also make purchases totaling $175 during that month. Then, on June 1, there would be a finance charge of 1 percent of the ending balance, which is $325 ($300 – $150 + $175). The finance charge would be $3.25. If you were being charged according to the adjusted balance method, the purchases of $175 you made in May would not be considered when determining your finance charge. Adjusted Daily Balance MethodThe most complicated method of calculating finance charges is the adjusted daily balance method (ADB). Let’s say you have a balance of $300 as of May 1. On May 16, 15 days into May, you make a purchase of $50. Then, 16 days later on June 1, your finance charge is calculated. The ADB method calculates a daily balance of $300 for 15 days and a daily balance of $350 for 16 days. The average daily balance is a calculation based on the 31 total days in May. Here is the equation:(15 × $300 + 16 × $350) ÷ 31 × 0.01 = $3.26.In this equation, the 0.01 is for the 1%. Note that on June 1, you would owe for the $350 for the purchases plus the finance charge, for a total of $353.26.This method gives you a lower finance charge than the ending balance method would. The ADB method is also fairer, since you did not use the $50 credit for the purchase you made for the entire month; you only used it for half of the month, starting on May 16. Understanding the different calculation methods for finance charges and knowing which one is applied to your credit card is an important part of maintaining your financial health.

ProfChris1 ProfChris1 · Answer 2 · 2022-04-29T13:48:15+02:00

We can actually deduce that interest rate is one of the biggest factors in calculating finance charges because of its impact on credit cards.

What is credit card?

Credit card refers to a form of card that is used for payment which is issued to users in order for the user to pay merchants for goods and services.

We see that interest rate actually adds a certain amount of money in percentage to actually pay the credit cards. This is carried out of it is not paid in full each month.

We see why the credit card is a biggest factor in calculating finance charges of credit cards.

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