How Credit Cards Work

By: Melanie Radzicki McManus  | 

Monthly Payments and Finance Charges

Credit card application
Whether you fill out an application for a credit card on paper or online, there are certain terms you need to know. courtneyk/Getty Images

Some credit cards require you to pay off all of your charges each month. As a benefit, they may offer no finance charge, and sometimes no maximum limit. (These might be more properly called charge cards.) Some types of American Express cards still use that model.

Most cards, including Visa, Mastercard and Discover, offer what is known as revolving credit. This means they let you carry a balance, on which they charge interest (finance charges), and they require you to make a minimum payment. The minimum payment is calculated differently by each card issuer. For example, Capital One charges either $25 or 1 percent of your new balance, plus interest (whichever amount is higher). Citibank, in contrast, charges whichever amount is higher: $35, or 1 or 1.5 percent of your new balance (depending on various circumstances, such as the terms of your credit card).


Here are three ways financial institutions calculate finance charges:

  • Adjusted balance. This system, which consumer experts say favors the cardholder, takes the balance from your previous statement, adds new charges, subtracts the payment you made and then multiplies this number by the monthly interest rate.
  • Average daily balance. This method, which is a pretty even-handed one and the most commonly used, works like this: The company tracks your balance day-by-day, adding charges and subtracting payments as they occur. At the end of the period, they compute the average of these daily totals and then multiply this number by the monthly interest rate to find your finance charge.
  • Previous balance. This method generally favors the card issuer, according to consumer experts. The issuer multiplies your previous statement's balance by the monthly interest rate to find the new finance charge. This means you're still being charged interest on your balance a whole period after you've paid it down!

What you pay will vary depending on your balance, the interest rate and the way your finance charge is calculated. Here's an example that shows how much difference the interest rate can make in what you actually end up paying:

  • High-rate card: Suppose you charge $1,000 on a 23.99 percent credit card. After that, you make no further charges and pay only the minimum each month. The payment will start at $51 and slowly work its way down to $10. You'll make 77 payments over the next six years and five months. By then, you will have paid $573.59 in interest for your credit privilege.
  • Low-rate card: If you charge that same $1,000 on a 9.9 percent fixed-rate card, the minimum monthly payment will start at $50.41 and go down to $10. You'll make 17 fewer payments, finishing in six years and paying $176 in interest. This saves you almost $400.

Late fees are used by pretty much all credit card issuers now. And increasingly, issuers are drastically raising interest rates (to as high as 29.99 percent) after a set number of late payments. Unfortunately, once you have a couple of late payments, the credit card company can charge you the inflated interest rate for the remaining life of the account. Try to avoid this — all credit card companies report your payment record to credit-reporting agencies, and even a few late payments could cause you problems when you try to buy a car or a house.

And as most of us know, even credit card companies make mistakes. The next section discusses how to make sure you're paying only what you owe.