Few people question the finance charge on their bank card statements, if they even notice it. They know they paid the bill late, or only in part, so they deserve some penalty, but they rarely examine the amount. Shrugs one man, "I don't care; I have to pay it anyway."
He probably should care, since he may be borrowing money at rates he doesn't understand, but he's hardly alone in paying it. In the average month, two-thirds of these accounts incur finance charges, says Spencer Nilson, whose Nilson Report covers the credit industry.
Even if all those consumers wanted to understand the amounts involved, they probably couldn't. "After you asked," says one 11-year card holder forlornly, "I read their explanation fully for the first time, and didn't understand it. I felt real dumb but I just couldn't figure it out."
Pushed to state their understanding of the principle involved, most caught something about a 1.5% to 1.7% monthly charge but have only dim ideas how it's applied and to what. Some make wild guesses: "I think they pick a date in the middle of the month, like your highest amount owing, and it's 1.5% of that." Most believe they're charged "about 1.5% a month on the unpaid balance" carried over to the next month. Thus, says one consumer, "if you have $100 due and you paid $20, they'd charge you 1.5% of $80," right?
Wrong. A few card holders rightly sense that the formula's more complicated, probably involving the "average daily balance" mentioned in small print. "It's computed on your average outstanding balance," says one economics expert, "going back to the beginning of that month"--the month that one had been late paying or had not paid in full. But how can this be, ask other people, noticing that the amount "subject to finance charges" is larger even than the sum total of the month's purchases, never mind the average daily balance. One woman's recent finance charges, for example, were calculated on $768.04 when her total purchases that month were only $457.96.
How It Works
What makes the difference is that the month that has its daily balances averaged (the adding together of outstanding balances at each day's end and dividing by the number of days) may not be the one the consumer thinks, and there may be not one but two months involved. In the most common system, for example, it is not the unpaid month but the next month whose balances are averaged for a finance charge.
To illustrate, let's say a bank's billing periods neatly follow calendar months (an unheard-of neatness), and that payments are due by the close of the next month. If a consumer spends $300 during September, gets his bill for it in early October, and doesn't pay in full by the end-of-October deadline, the bank's computer will tally up all the daily balances for October (not September), apply the finance charge to the average of them, and add it to his early November statement. He could thus have finance charges on much more than the unpaid $300, because "October's daily balances", says Robert White, compliance officer in Wells Fargo's credit card division in San Francisco, "equal what was there (from September) plus anything else that comes in, including new purchases."
Some people think it intrinsically unfair to tack a charge on payments before they are due, before one has had a chance to pay them at all. Indeed, there are other ways of compounding the sum to which the finance charge is applied. Security Pacific National Bank, for one, calculates September's average daily balance and applies the finance charge to that. Then it moves on to October, applying the finance charge again to the total, final September balance carried unpaid through October's 30 days (but not including October's purchases), and levies on the consumer the sum of the two finance charges. Thus, though Security doesn't count in new purchases, it has a similar base for finance charges, including one full month of averaged balances and one full month of unpaid September balance.
Even More Complicated
Actually, it's even more complicated, because most banks have an entirely separate interest charge for cash advances--applicable even when they're paid on time--and extra "late charges" (usually a percent of the unpaid balance) for consumers who don't make any minimum payment. Even bank personnel cannot explain the accounting without resorting to worksheets on which they lay out two month's worth of activity day by day. "The hardest part," says Barry Wolfgram, Bank of America's vice president of credit extension in the bank card division, "is that unlike a fixed loan, where someone gives you $1,000--a single event--and charges you 10% a month, there are so many events happening every month."
Nevertheless, it's a mistake to think of that interest rate as a late charge applied to an unpaid balance: Bank card credit is a loan, and the charges are interest on money borrowed for the time it's borrowed. "The computer has been counting all along," says Barbara Evans, known as "the APR czar" at Security Pacific because she's in charge of credit policy and procedures, "adding up all the daily balances for the applicable period," and when the amount owing is not paid off by the cutoff date, charges are levied.
The difference is that if these loans (with few exceptions) are paid off in full by the time due, the interest accrued is wiped out, making it an unusual loan as well as "a very convenient way of borrowing money," says Security Pacific Senior Vice President Gregory Bjorndahl. "If you pay it back by the next statement period, you pay no interest, and have had free use of the money."