Borrowing

The costs of borrowing

Credit costs money! The cost of credit will vary considerably depending on the method used to calculate the balance on which you pay a finance charge. It is often difficult to figure out the finance charges once you start using a credit card regularly and carrying a balance on it. The bottom line about finance charges on credit cards is this: Try to pay off your credit cards each month. If you can't afford to pay off your credit cards each month, make the largest payment you can afford, and pay the card off before you make another purchase.

The four methods for calculating finance charges are:

• Adjusted balance takes the amount you owed at the beginning of the billing period and subtracts any credits and any payments you made during the period. New purchases are not counted.
• Average daily balance (one of the most common methods) adds your balances for each day in the billing period and divides that total by the number of days in the period. Additionally, payments and credits made during the period are subtracted and new purchases may or may not be included.
• Two-cycle average daily balance uses the average daily balances for two billing periods to calculate the finance charge. Payments and credits will be accounted for and new purchases may or may not be included.
• Previous balance bases the finance charge on the amount owed at the end of the previous billing period.

How do these different methods affect the finance charge?
The Bankcard Holders of America (BHA) calculated the finance charges on one account four different ways. The account started with a zero balance the first month. The account holder then charged $1000 and made the minimum payment. The next month, the account holder charged another $1000 and paid off the balance due. The account's interest rate is 19.8%. The calculations showed varying interest between $16.50 and $49.05. It pays to shop around!

• Average daily balance method, including new purchases: $33
• Average daily balance method, excluding new purchases: $16.50
• Two-cycle average daily balance method, including new purchases: $49.05
• Two-cycle average daily balance method, excluding new purchases: $32.80

Some credit card issuers offer variable interest rate plans that drive the rate to be charged by using a formula. A common formula is:

Index + Margin = Variable rate.

Some of the common indexes used by credit card issuers are the prime rate, the one-, three-, or six-month Treasury Bill rate, or the federal funds or Federal Reserve discount rate. Most of these indices can be found in the money or business sections of the paper. The issuer then adds a number of percentage points, the "margin," to the index rate to calculate the rate charged. Another formula to determine the rate to be charged uses a multiplier -

Index x Multiple = Variable rate.