Friday, February 4, 2011

Safeguarding Your Money

by Thomas Duffany III

Office for Financial Success Counselor


My wife is much smarter than I am.  If we disagree on something she turns out to be right 90% of the time (don’t tell her I admitted to that!).  That is why I was somewhat surprised when she started asking me questions about how interest is charged if a credit card is not paid off in full at the end of the month.  I answered with terms like “average daily balance method” and “grace period” but more specific questions came including scenarios.  Understanding these principles and their application can help you keep your money where you want it…in your wallet.


The Basics 


Credit card companies use the average daily balance method to calculate the interest you are charged each month.  The average daily balance is calculated by adding the balance from the end of each day during the billing period and dividing by the number of days in that billing period.  Look at the following scenario:


Starting Balance: $0

Purchases:                                                          Balance:                               Total:

Dec 6     $60         Groceries                            Dec 6 – 14            $60         9 days * $60 = $540

Dec 15   $150       Car Payment                      Dec 15 – 17         $210       3 days * $210 = $630

Dec 18   $80         Winter Coat                        Dec 18 – Jan 1    $290       15 days * $290 = $4350

Jan 2      $50         XBox Game                        Jan 2 – Jan 5       $340       4 days * $340 = $1360 

                                                                                                                31 days                 $6880/31 = $221.94

The average daily balance for this billing period is $221.94.  A certain number of days are provided after the billing period ends in which to pay the balance off in full without accruing any interest – the grace period.  The interest rate shown on the statement is the APR or annual percentage rate.  This is the amount you would accrue over the course of an entire year.  Because we are working with a daily balance we will have to adjust the rate to a daily figure:


APR (Annual Percentage Rate): 12.9%/365 days = 0.035% daily interest rate


Total interest accrued: 0.035% or 0.00035 * $221.94 * 31 days = $2.41 Most credit card companies have a minimum amount of interest they charge, often about $5.  In this instance rather than paying the $2.41 that accrued, you would pay the minimum amount. 


The trap many people fall into is to think that $5 isn’t that much.  They make the minimum payment and continue making purchases.  Before long their balance is high and their interest payments are much more substantial.  For instance, after just 6 months of paying only the minimum and continuing similar usage as this example, the balance will be close to $2000 and you will be accruing $20 of interest each month.  If you stopped using your credit card and made only minimum payments it would take you years to pay it off!


My wife and I developed a habit of only using our credit card for purchases we could pay off at the end of the month.  This is why she had never made it a point to be clear on the specifics.  However, this particular month we had some unexpected expenses and we had to make some decisions:  How much can we pay now and how can we minimize interest payments? 


Common Questions 


Question: If I make a partial payment will I still be charged interest on that amount?  Answer: Yes.  Going back to our example, the ending balance was $340.  If you decided to pay $200 that would bring the balance to $140.  However, interest is not calculated using the final balance or the balance after your payment.  It is calculated using the average daily balance during the billing period: $221.94.  Therefore, if you do not pay off the entire balance, the interest charge will be the same no matter how much you pay.


Question: I went to my online statement and saw two different balances, a statement balance and a current balance.  What is the difference and on which balance will I be charged interest?  Answer: The current balance includes all charges that have posted to your account up to the present day.  The statement balance includes only the charges posted to the account by the end of the billing period.  Going back to our example, the ending statement balance was $340.  The payment would likely be due around January 26 (21 days after the billing period ended).  If a $60 charge posted to the account on January 10, before you made a payment, the current balance would be $400 and the statement balance would remain $340.  The grace period refers to the statement balance only.  Therefore, in the case of our example, a $340 payment would be sufficient to avoid interest payment even though the current balance was $400.  Current balances are never used to calculate interest payments.


Question:  I paid my statement balance in full, so why was I still charged interest?  Answer: Likely because you did not pay the full balance the previous month.  If you make only a partial payment you will continue to accrue interest until you start a billing period with a $0 balance.  Returning to our original example, if you only paid $200 at the end of that billing period, you would start the next billing period with a balance of $145 (accounting for $5 of interest).  Interest for the next billing period would be calculated as follows:


Starting Balance: $145


                                                                Jan 6 – Jan 9       $145       4 days * $145 = $580

Jan 10    $60         Clothes                 Jan 10 – Jan 17   $205       8 days * $205 = $1640

Jan 18    Paid the full balance       Jan 18 – Feb 5    $0           19 days * $0 = $0         

                                                                                                                31 days                 $2220/31 = $71.61

Total interest accrued:  .00035 * $71.61 * 31 days = $0.78 (minimum interest charge applies).


The next billing period would begin on February 6 with a balance of $0.  If you paid the balance off in full at the close of that billing period you would pay no interest.  Even if you don’t use your card during that billing period you may have an interest charge from the previous billing period.  Be sure to always check your account so you don’t miss a payment (and to prevent fraudulent charges from being missed).


We often make things more complicated than they need to be.  There are many other scenarios we could discuss but just remember it always comes down to the same principles: grace period, average daily balance, and billing periods. 

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