What is Average Daily Balance Method
The average daily balance is a common accounting method where credit card interest charges are calculated using the total amount due on a card at the end of each day. The average daily balance totals each day's balance for the billing cycle and divides by the total number of days in the billing cycle. Then, the balance is multiplied by the monthly interest rate to assess the customer's finance charge.
BREAKING DOWN Average Daily Balance Method
Dividing the cardholder's annual percentage rate (APR) by 12 calculates the monthly interest rate. The balance generates less interest due than the previous balance method, because payments made toward the credit card balance immediately lowers the total balance. This balance is typically the most profitable for credit card companies.
Effect on Balances
The average daily balance calculates interest by considering the balance invested or owed at the end of each day of the billing period rather than the balance invested or owed at the end of the week, month or year.
Compound interest affects how borrowers and lenders use the average daily balance method. Borrowers and lenders use the balance to calculate interest if the interest compounds monthly. An investor must understand how an institution's choice of accounting methods used to calculate interest affect the amount of interest deposited into investor’s account.
How It Works
Some credit card companies previously used the double-cycle billing method that assessed a customer’s average daily balance over the last two billing cycles, which was a justification for charging more interest. The credit card company totaled a customer’s balance each day during the billing cycle, added these balances together and divided by the number of days in the billing period. A billing period is usually a 30-day period.
The average daily balance credits a customer’s account from the day the credit card company receives a payment. To assess the balance due, the credit card company sums the beginning balance for each day in the billing period and subtracts any payments as they arrive and any credits made to the customer’s account that day.
Cash advances are usually included in the average daily balance. The total balance due may fluctuate daily because of payments and purchases. For example, a credit card has a monthly interest rate of 1.5 percent, and the previous balance is $500. On the 15th day of a billing cycle, the credit card company receives and credits a customer’s payment of $300. On the 18th day, the customer makes a $100 purchase. The average daily balance is (14 x 500) + (16 x 200) = / 30 = (7,000 + 3,200) / 30 = $340. The bigger the payment a customer pays and the earlier in the billing cycle the customer makes a payment, the lower the finance charges assessed.
There are several interest calculation methods in use; therefore, borrowers should compare credit card offers from lenders, and investors should compare investment offers by reading the disclosure that accompanies those offers to ensure that they select a product that meets their needs.