There are a few different methods that businesses use to calculate finance charges, and they all have their pros and cons. But which one is the worst? In this blog post, we’ll take a look at the different methods and see which one is the most harmful to your bottom line.
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The Different Methods of Computing Finance Charges
In the world of credit cards, there are many ways that a finance charge can be assessed on your account. And depending on how your credit card issuer calculates your balance, the method used to calculate your finance charge can end up costing you more money in the long run.
Here are some of the different methods used to calculate finance charges, along with a brief explanation of how each one works.
Average Daily Balance: This method takes the average of your balance over the course of a billing cycle, then multiplies that number by the daily periodic rate and the number of days in the billing cycle.
Previous Balance: This is probably the simplest method of computing a finance charge. Your issuer simply multiplies your previous balance by the periodic rate to arrive at your finance charge for the current billing cycle.
Balance at Statement Date: With this method, your issuer uses whatever balance is reported on your statement as of its closing date. That balance is then multiplied by the periodic rate to determine your finance charge for that billing cycle.
Why the Average Daily Balance Method is the Worst
As consumers, we’re often inundated with choices when it comes to credit cards. Do you want cash back or points? A low interest rate or no annual fee? One choice that’s not as well publicized is which method the credit card company uses to calculate your finance charges.
You may not realize it, but there are actually three different ways that your credit card company can choose to calculate your finance charges. These methods are the average daily balance method, the adjusted balance method, and the previous balance method. (There’s also the two-cycle average daily balance method, but we’ll save that for another day.)
So which one of these methods is the worst? The answer might surprise you — it’s the average daily balance method.
Here’s how it works: let’s say you have a credit card with a $1,000 limit and a 20% APR. Under the average daily balance method, your finance charges would be calculated based on your average daily balance during the billing cycle. So, if you had a balance of $500 on Monday and spent $50 on Tuesday, your average daily balance would be $525 ((500+525)/2). Based on this calculation, your finance charges would be $10.50 (($525 x .20)/365)).
The problem with this method is that it doesn’t take into account when you made your purchases. Under this method, you would be charged interest on the full $500 from Monday even though you only spent $50 on Tuesday. In contrast, under the adjusted balance or previous balance methods, you would only be charged interest on the $50 that you spent on Tuesday.
To put it simply, the average daily balance method is unfair because you’re being charged interest on money that you may not even owe anymore. And no one likes to getcharged for something they don’t owe!
Why the Two-Cycle Average Daily Balance Method is the Worst
There are many different ways that lenders can calculate finance charges on credit card balances, but the two-cycle average daily balance method is often considered to be the worst.
Here’s how it works: the lender looks at the balance for each day of the billing cycle, adds them all together, and then divides by the number of days in the billing cycle. This gives them the average daily balance. They then multiply this by the monthly periodic rate and divide by 100 to get the finance charge for that billing cycle.
So why is this method so bad? First, it doesn’t give any break to cardholders who pay their balance in full every month and only carry a balance for part of the month. Second, it encourages people to keep a higher balance on their card since that will lower their finance charges. And finally, it’s just needlessly complicated!
There are two other methods that are used more often now which are fairer to consumers: the daily periodic rate method and the adjusted balance method. With the daily periodic rate method, finance charges are calculated by multiplying the daily periodic rate (which is just the monthly periodic rate divided by 30) by the number of days in the billing cycle that there was a balance on the account. So if you carried a balance for 10 days out of a 30-day billing cycle, your finance charges would be based on 10 days instead of 30.
With the adjusted balance method, finance charges are calculated using this formula: Previous Balance – Payments & Credits + New Purchases & Other Charges + Fees = Adjusted Balance x Daily Periodic Rate x Number of Days in Billing Cycle = Finance Charge
As you can see, this takes into account payments and credits made during the billing cycle, which means that cardholders who pay their balance in full every month won’t be charged any finance fees. And it also uses a more straightforward calculation than the two-cycle average daily balance method.
Why the Adjusted Balance Method is the Worst
There are a few different ways that credit card companies can calculate your finance charges, and some are definitely better than others. The adjusted balance method is the worst of the bunch, and you should avoid it if possible.
Here’s how the adjusted balance method works: your finance charges are calculated based on the balance on your statement at the end of the billing cycle, minus any payments or credits that have been applied during that same cycle. So, if your balance was $1,000 and you made a payment of $250 during the cycle, your finance charges would be calculated on a $750 balance.
The problem with this method is that it doesn’t take into account any new purchases made during the billing cycle. So, if you make a purchase on the first day of the billing cycle and don’t make a payment until the last day, you’ll be charged interest on that entire purchase amount from day one. That’s not fair, and it’s not how other methods work.
Other methods, like the average daily balance method, factor in new purchases when calculating finance charges. This means that you won’t be charged interest on new purchases until after the grace period has ended (if your card even has a grace period). This is a much more fair way to calculate finance charges, and it’s why we recommend avoiding cards that use the adjusted balance method.
Why the Previous Balance Method is the Worst
If you have ever been charged interest on your credit card balance, you’ve likely wondered how the company arrived at that number. Credit card companies use one of four methods to calculate interest charges, and each has its own formula. The method used can impact how much interest you pay, so it’s important to understand how each one works.
Of the four methods, the previous balance method is generally considered the worst because it doesn’t consider recent activity. With this method, your finance charge is based on the balance from your previous statement. So, if you made a payment after your last statement was issued but before the current one, that amount won’t be credited towards your balance and you’ll still be charged interest on the full amount.
Why the Statement Balance Method is the Worst
Every credit card charges interest on the outstanding balance. The way the credit card company calculates this interest charge is important. The three common methods are average daily balance, adjusted balance, and previous balance. Of these three methods, the worst is the statement balance method.
The statement balance method bases the finance charge on the balance stated on the most recent monthly statement. To calculate the finance charge, the credit card company takes the statement balance and multiplies it by the daily periodic rate and then multiplies that number by the number of days in the billing cycle.
There are two problems with this method. One is that it does not give credit for payments you make during the month; those payments are not reflected in the statement balance. The other problem is that it includes new purchases in the finance charge even though you have not had use of those funds all month long. This can result in a substantial finance charge on a relatively small outstanding balance.
For these reasons, it is always best to use a credit card that uses either the average daily balance or adjusted balance method to compute finance charges.
Why the Minimum Payment Due Method is the Worst
The minimum payment due method is the most common way that lenders compute finance charges, but it is also the worst method for borrowers. Under this method, the finance charge is based on the amount of the outstanding balance that is subject to interest, regardless of when during the billing cycle the purchase was made. The result is that consumers who make purchases early in the billing cycle and pay their bills on time are penalized by having to pay finance charges on those purchases for a full month. On the other hand, consumers who make purchases late in the billing cycle and carry a balance forward are rewarded because they pay less in finance charges.
Why the Fixed Charge Method is the Worst
The Fixed Charge method is the worst because it always charges a fixed finance charge regardless of the balance. This doesn’t make sense because if you have a small balance, you should pay less in finance charges than if you had a large balance. TheFixed Charge method is often used by commercial businesses to calculate monthly finance charges on past due accounts.
Why the Tiered Rate Method is the Worst
The tiered rate method is the most common method used by banks to charge finance fees, and it is also the worst. With the tiered rate method, the closer your balance is to your credit limit, the higher your finance charge will be. For example, if your credit limit is $1,000 and your ending balance is $999, you might be charged a 5% finance fee on that balance. If your ending balance was $950, you would be charged a lower finance fee.
The reason the tiered rate method is the worst is because it penalizes people who carry a balance from month to month. If you always pay off your balance in full, you will never pay a finance charge using this method. But if you carry a balance, you will always be charged a higher finance fee than someone who doesn’t carry a balance.
There are two other methods of computing finance charges that are fairer to consumers: the daily periodic rate method and the average daily balance method. With the daily periodic rate method, your finance charge is based on the number of days in your billing cycle multiplied by the daily periodic rate (which is your annual percentage rate divided by 365). So if your annual percentage rate is 18% and you have a 30-day billing cycle, your daily periodic rate would be 0.05% (18% divided by 365 days), and your finance charge for the month would be $0.50 (30 days multiplied by 0.05%).
With the average daily balance method, your finance charge is based on the average of your balances during the month. To calculate this, you add up all of the balances during the month and divide by the number of days in the month. So if you had a balance of $1,000 on day 1 of your billing cycle and $1,200 on day 2, your average daily balance would be $1,100 ($2,200 divided by 2 days). If you carried that average daily balance for 30 days in a row, your finance charge for that month would be $33 ($1,100 multiplied by 3%).
The best way to avoid paying interest charges is to always pay off your balance in full each month. But if you do carry a balance from time to time, it’s important to know how your bank calculates finance charges so you can minimize those charges as much as possible.”
Why the Pay-As-You-Go Method is the Worst
There are a number of different methods that financial institutions use to calculate finance charges on credit cards. The three most common methods are the:
-Average Daily Balance Method
-Adjusted Balance Method
-Previous Balance Method
Of these three, the Pay-As-You-Go method is generally considered to be the worst for borrowers. Here’s why:
With the Average Daily Balance method, your finance charge is calculated based on the average of your balance over the course of the billing period. This means that if you have a high balance one month and a low balance the next, your finance charges will even out somewhat.
The Adjusted Balance method is similar to the Average Daily Balance method, except that it excludes any payments you made during the billing period. This can be advantageous if you paid off a large portion of your balance during the month, as your finance charges will be lower.
The Previous Balance method simply assesses finance charges on your entire outstanding balance from the previous month. This method is generally considered to be unfair to borrowers because it doesn’t take into account any payments or credits that were made during the current billing period. It also means that if your balance goes up for any reason (including interest and fees), your finance charges will increase as well.
The Pay-As-You-Go method is similar to the Previous Balance method, except that interest is charged on every purchase immediately, regardless of when you make a payment. This can result in sky-high finance charges if you don’t pay off your entire balance every single month. For this reason, it’s generally best to avoid credit cards that use this method of computing finance charges.