How to calculate finance charge
Understanding how to calculate finance charges is essential for anyone who wants to properly manage their debts and avoid surprises. Finance charges are the fees you pay to borrow money, including interest and fees charged by a lender. In this article, we will explore different methods of calculating finance charges so you can maintain better control over your finances.
Understanding Finance Charges
Before diving into the calculations, it is important to understand what finance charges are. The term can refer to several types of fees that a borrower might incur, such as interest and some other additional costs. Generally, finance charges are calculated based on the outstanding balance of your loan or credit card at the end of each billing cycle.
Methods for Calculating Finance Charges
1. Daily Balance Method:
This method calculates finance charges by applying the daily periodic rate (DPR) to the adjusted balance for each day in the billing cycle. To calculate finance charges using this method:
a. Determine your annual percentage rate (APR).
b. Divide your APR by 365 days to get the DPR.
c. Multiply the DPR by your account balance for each day.
d. Add up these amounts for all days in the billing cycle.
2. Average Daily Balance Method:
This popular method calculates finance charges by applying the DPR to the average daily balance during the billing cycle. To calculate finance charges using this method:
a. Determine your APR and divide by 365 days to find DPR.
b. Calculate the balance for each day during the billing cycle.
c. Find the sum of all daily balances and divide by number of days in the billing cycle.
d. Multiply this average daily balance by DPR and billing cycle length (days).
3. Previous Balance Method:
This method calculates finance charges based on your account balance from the previous billing cycle, instead of considering any new transactions or payments made in the current cycle. To calculate finance charges using this method:
a. Determine your APR and divide by 12 to find monthly periodic rate (MPR).
b. Multiply MPR by the account balance at the end of the previous billing cycle.
4. Adjusted Balance Method:
This method is similar to the previous balance method; however, it takes into account any payments made during the billing cycle. To calculate finance charges using this method:
a. Determine your APR and divide by 12 to find MPR.
b. Subtract any payments or credits from the balance at the end of the previous billing cycle.
c. Multiply MPR by this adjusted balance.
Calculating finance charges is a crucial skill for managing your debts effectively. By understanding how different methods are employed, you can make informed decisions about your borrowing expenses and financial management practices. Always read lender agreements carefully to know which calculation method is being used and regularly check statements to ensure accuracy.