A finance charge is the interest you pay on borrowed money such as credit card balances. It is expressed in a standardized way as an annual percentage rate (APR). The APR is equivalent to the interest rate, but may be higher if it includes fees. Your monthly credit card statement shows you how your finance charges were calculated, but you can calculate them yourself as well.
Daily Interest Rate
Credit card companies calculate finance charges on a daily basis. The daily rate is the APR divided by 365. For example, if your credit card has an 18 percent APR, the daily interest rate is 0.04932 percent. Each day's finance charge is equal to the eligible balance multiplied by the daily interest rate. For example, if you owe $500 on your credit card with an 18 percent APR, you daily finance charge is (0.0004932 x $500), or $0.2465. If your daily balance remains $500 for the 30-day billing cycle, the month's finance charge is (30 x $0.2465), or $7.40.
Your credit card's daily balance isn't necessarily the basis for your finance charges, because you receive an interest-free grace period on new purchases until the next billing date. Once the grace period expires, the new purchase balance joins the total balance eligible for interest charges. Your monthly finance charge is the sum of your daily interest charges. Your daily balance varies as you send payments and charge new purchases.
Most credit cards employ daily compounding, which slightly increases the finance charges you pay. Compounding means the interest you incur today is added to your daily balance, so you will have to pay interest on the interest, starting tomorrow. In the credit card example with a daily finance charge of $0.2465, the first day of interest on a newly eligible $500 balance is added in to create a new balance, on the next day, of $500.2465. When multiplied by the daily interest rate of 0.04932 percent, the second day interest charge is (0.0004932 x $500.2465), or $0.2467.
Video of the Day
The cycle repeats daily. As you can see, the daily finance charges mount up faster due to compounding, and the monthly charge in this example will be a little more than the uncompounded amount, $7.40. You can use an online finance charge calculator to compute compounded finance charges. Some credit cards compound on a different basis, such as continuously or monthly.
The example applies to the finance charges on credit card purchases. Credit card cash advances frequently have a higher APR and no grace period. The APR on your credit card is equal to the prime rate plus an extra amount (a "spread') based on your credit score, and a change to either can affect your APR. The APR on new purchases is zero during the grace period.
Some credit cards offer extended grace periods for new customers. For example, you might not have to pay interest on purchases for the first nine months when you open a new credit card.