Grace Period

The length of time that the loan is considered outstanding, and thus the length of time over which interest is due, is an important factor is computing the amount of interest, especially on credit card debt. Lenders use one of four basic methods to determine the amount of time for calculating interest. However, be aware that lenders can use different methods for different types of transactions. For example, a "cash advance" on a credit card is often charged interest beginning with the day of the advance--even if there is a grace period for purchases.

Past-due balance method. This method is used to stimulate customers to repay their accounts fully. Customers who pay their accounts in full within a specified time period, such as 30 days from the billing date, do not have to pay any interest. This is often referred to as the "grace period."

Previous balance method. This is the most expensive for the customer because interest is computed on the outstanding balance at the beginning of the period and does not take into account any payments that were made during the period. If at all possible, avoid cards that you this method!

Average daily balance method. The interest is charged on the average daily balance of the account over the billing period. Using this method is less expensive than the previous balance method and is widely used by lenders that offer revolving charge accounts.

Adjusted balance method. The interest is computed based on the balance remaining at the end of the billing period ignoring purchases or returns made during the billing period. This method will result in lower interest charges than either the previous balance method or the average daily balance method.

Assume that the monthly interest rate is 1.5 percent, which represents an annual rate of 18 percent. The previous balance is $400 and a payment of $300 was made on the 15th of the month. The finance charge under each of the four methods is: Past Due Balance Method: $ 0.00 Previous Balance Method: $ 6.00 Average Daily Balance Method: $ 3.75 Adjusted Balance Method: $ 1.50