If you do an APR comparison between credit cards, make sure you also look at how the APR is calculated by each card issuer. When credit card companies calculate APR, they do so in a variety of different ways to determine what finance charges you’ll owe each billing period.
Two common ways of calculating credit card APR are the “average daily balance” method and the “two-cycle average daily balance” method.
It’s important to understand the difference between these two popular interest calculating methods to effectively save the most money, and avoid costly finance charges.
Average Daily Balance
“Average daily balance” is the most common form of balance computation by credit card companies. This method of calculating APR takes your average daily balance for each day of the billing cycle, then takes the sum of the balance for every day in the billing cycle and divides it by the amount of days in the billing cycle.
For example, if you had a consistent balance of $500 per day for the full 31 days in your billing cycle, your calculations would look like this:
$500 x 31 / 31 days = $500.00 average daily balance
But if you had a balance of $500 for the first 15 days and $1000 for the last 16 days of the billing cycle, your calculations would look like this:
$500 x 15 + $1000 x 16 / 31 days = $758.06 average daily balance
The credit card issuer would then take the average daily balance, multiply it by your APR, and then divide it by 12 (months). Let’s assume you have an APR of 28%.
In the first example above, your monthly finance charge would be $11.67. In the second example, your finance charge would be $17.69.
So as you can see from the data above, the more days in your billing cycle that you carry a large balance, the greater the resulting finance charge. That’s why it makes sense to pay off balances as soon as possible.
Read more: How are credit card minimum payments calculated?
Two-Cycle Average Daily Balance
“Two-Cycle Average Daily Balance” is a less common APR computation method, though it’s used widely by Discover card and other card issuers. This is typically the most expensive way of calculating APR because it takes into account two months of your average daily balance.
To figure out the APR, it takes the sum of your average daily balance for your current and previous billing cycles, then multiplies it by the APR and divides that total by 12 (months).
The finance charges are based on the current and previous billing cycles, so a large average daily balance during the prior billing cycle will lead to higher finance charges the following month if you carry a balance.
Let’s look at an example:
Say you had an average daily balance of $1500 during your previous billing cycle and $500 during your current billing cycle. Though you paid off a good chunk of your previous credit card balance, the two-cycle average daily balance would be calculated as $1000 (the sum of the last two months average daily balance, $2000, divided by 2), not the $500 balance you currently carry.
This would effectively double the finance charge, making it less attractive to carry a high balance on your credit card(s) that employs the two-cycle average daily balance computation method.
That’s why it is extremely important to make sure you understand how your finance charges are calculated.
Don’t be afraid to call your credit card issuer to get a full explanation of how it works and when finance charges are applied to your account. Be sure to get details on the credit card grace period as well so you can avoid finance charges altogether.
The best policy is to pay your credit card in full every month. If you do, it doesn’t really matter how the finance charges are calculated because you won’t have to pay any.
Update: The CARD Act banned double-cycle billing, otherwise known as two-cycle billing, (partially because no one could actually understand it) so it’s no longer a concern for consumers.