How paying your bill early saves money

For credit card customers who carry a balance month-to-month—something I strongly discourage—there is a simple way to reduce finance charges: make payments earlier than the due date.

Here is how it works mathematically.  To calculate finance charges, most credit card companies use your Average Daily Balance (ADB), which is the total of the balance at the end of each day during a period divided by the number of days in the period.   For example, CapitalOne calculates its finance charges using your Average Daily Balance.  Here is what CapitalOne’s fine print says:

“Finance charge is calculated by multiplying the daily balance of each segment of your account (e.g., cash advance, purchase, special transfer, and special purchase) by the corresponding daily periodic rate(s) that has been previously disclosed to you.  At the end of each day during the billing period, we apply the daily periodic rate for each segment of your account to the daily balance of each segment.  Then at the end of the billing period, we add up the results of these daily calculations to arrive at your periodic finance charge for your account.”

There is more fine print and special cases, but I don’t want to put you to sleep.  In a nutshell, the higher your daily balance, the more you pay in finance charges.  Thus, it pays to reduce your balance whenever you can. 

For instance, let’s say your incoming balance for a billing cycle in April is $1,000.  For the first five days of the billing cycle, you make $400 worth of purchases ($250 on Apr. 2 and $150 on Apr. 3). Also, your Annual Percentage Rate (APR) is 15.9%, and therefore your Periodic Rate is 0.04356% (APR divided by 365 days).  Below is what your Average Daily Balance and finance charges computation would look like. 

DATE	PURCHASES	PAYMENTS	BALANCE	FINANCE CHARGE
Apr 01			$1,000	$0.44
Apr 02	$250		$1,250	$0.54
Apr 03	$150		$1,400	$0.61
Apr 04		$800	$600	$0.26
Apr 05			$600	$0.26

Total Daily Balances	$4,850
Number of Days	5
Average Daily Balance	$970
Total Finance Charges	$2.11

Now, let’s consider the entire 30-day billing cycle.  If you didn’t make any more transactions after Apr. 5 and waited to make your $800 payment on the due date May 1st, your average daily balance would be about $720 higher and would cost you about $10 more in finance charges.  Thus, your finance charges would be much more.  If you tend to make especially large transactions using a credit card, paying early will help you save a significant amount of money. One exception is if you pay within the grace period, a period of about 25 days during which no finance charges are applied.  

In short, it pays to pay early.  In fact, you can even devise a plan for paying a bill twice a month instead of once.  I often do just that, or after a large transaction, I’ll make a payment that same day for the amount I just charged.  And for those of you who are thinking about paying more than you owe: no, the companies will not pay you extra. 

Comments

[ClubPenguinCheats]

I have my payment schedule set up so that I can pay my cards either same day or within a week that the statement is generated.

[Nicola Dupont]

This is good how we put it out the American people.
There is so many good books about managing debt.
But people don't want to learn they take advice from friends that are in debt too.

I'm a realtor if I show this to my friends they will say what the heck are you talking about?

good books
Dave Ramsey Manage your Money
Luis Maqueira Eliminate Debt 101

[Jazzy]

I can attest to this as well. I have my payment schedule set up so that I can pay my cards either same day or within a week that the statement is generated. While I still receive the paper statements in the mail, I always check online and pay right away to avoid the daily interest rate. This discipline has saved me so much money-- so much so, that I may be able to be debt free two months sooner than expected.

As usual, you have great advice!

[James W. Barnett]

This is so important, making multiple payments saved me a ton of money. I suggest this to anyone who is paying interest on a loan. When I suggest this smart payment method many people say they don't have the extra money to make multiple payments. That's not case break your monthly payment up in 2 or 3 payments:

For example your car note is $400/mo make a $100 payment per week. (I did this a few yrs back and beat the balance down on the car in no time) that allows more of your payment to go to princlple instead of interest.

Food For Thought: I even went to the exent to contact the lender and push my due date back to the end of the month so I can make multiple payments. Most companys don't have a problem pushing your due date back to 30th 31st of the month.

For anyone reading this just try it and after about 3 months look at your statement and see how much is going towards princlpe and interest, you would be AMAZED!!! Good Luck

JB