What Is the Past Due Balance Method?
The past due balance method is an approach to calculating interest on a loan. Under the past due balance method, the borrower is given a grace period prior to which they will not be charged interest on the outstanding balance of the loan.
This approach, which is advantageous to the borrower, is commonly employed by credit card companies.
- The past due balance method is a system for calculating interest.
- It is commonly used by credit card companies, and is considered advantageous for the borrower.
- Under the past due balance method, borrowers who pay off their full balance within the prescribed grace period can effectively profit from their use of the loan.
How the Past Due Balance Method Works
Under the past due balance method, borrowers enjoy an interest-free period on new borrowings. As long as they repay the outstanding balance as of the end of that period, they will not incur any interest. In the context of credit cards, the grace period is typically between 20 and 30 days, and is set to overlap with the card’s billing cycle. Oftentimes, the payments are due at the end of each month, although the exact can differ depending on the card provider and the date at which the card was issued.
From the perspective of the lender, the past due balance method increases their exposure to prepayment risk. After all, if a large number of borrowers pay off their debts within the prescribed grace period, then the lender will have effectively given them an interest-free loan. Since the lender must cover their own operational and financial costs—including the cost of inflation—they will inevitably lose money on such interest-free loans, when viewed on a net basis.
For borrowers, however, the past due balance method can be highly attractive. If the borrower is diligent in paying off most or all of their debts within the grace period, then they can improve their cashflow by receiving low-cost or zero-cost credit from the loan provider. At the same time, such habits can also help improve the borrower’s credit score, while entitling them to peripheral benefits such as participating in the lender’s cash-back or rewards programs. For these reasons, lenders who use the past due balance method are relying on the assumption that a significant percentage of their customers will fail to pay off their loans on time, and will therefore begin to accrue interest or other penalties.
Real World Example of the Past Due Balance Method
Mia is reviewing the cardholder agreement for her new credit card. She notes that the card uses the past due balance method, providing a 28-day grace period. On the 28th of each month, all outstanding balances begin to incur interest charges, meaning that she can avoid paying any interest as long as she pays off her full balance before this date. At the same time, any unpaid balances left beyond that grace period will begin to incur interest charges. For example, if Mia incurs $500 of expenses and pays off $400 as of the end of day 28, then interest would begin accruing on the $100 unpaid balance.
After reviewing these terms and the other provisions of the cardholder agreement, Mia decides to proceed with the card. After all, she is already in the habit of paying off her full card balance at the end of each billing cycle. Therefore, she is not concerned with the risk of incurring interest beyond the 28-day grace period. At the same time, she will be able to benefit from the card’s cash-back and reward programs, meaning that she can effectively profit from her use of the card.