Average Daily Balance Method

Image: Moneybestpal.com

Credit card interest rates are frequently determined using the average daily balance approach. It is based on the amounts left on the card on each day of the payment cycle. 

The daily periodic rate for the card is multiplied by the number of days in the billing cycle, and the result is the average daily balance.

The annual percentage rate (APR) of the card is divided by the number of days in the year to determine the daily periodic rate. The annual percentage rate (APR) is the interest rate that the credit card company levies on money borrowed. The card issuer, the kind of card, and the cardholder's creditworthiness can all affect the APR.

The card issuer starts with the balance at the beginning of each day, adds any new charges for that day together with any interest charges on the previous day's amount, and then deducts any payments or credits that day to arrive at the average daily balance. 

The card company then totals all daily balances, divides that sum by the number of days in the billing cycle, and then calculates the total. The average daily balance is the outcome.

As an illustration, let's say you have a credit card with a 30-day billing cycle and an APR of 18%, and you have a $500 amount at the start of the month. You make a $200 new purchase with the card on the tenth day of the billing cycle. Then, on the twenty-fifth day of the billing cycle, you make a $300 payment toward the credit card's unpaid amount.

Given these circumstances, your daily balance for each day in the billing cycle would be as follows:


Day 1-9, the daily balance is $500

Day 10-24, the daily balance is $700 (due to the $200 purchase made on day 10)

Day 25-30, the daily balance is $400 (following your $300 payment)

You must add up the balances for all of the days in the billing cycle, then divide the amount by the number of days in the billing cycle, in this case 30, to determine your average daily balance for the whole billing cycle.

The sum total of your daily balances is:


(9 x $500) + (15 x $700) + (6 x $400) = $15,900


The average daily balance is:


$15,900 / 30 = $530


To calculate your interest charge for that month, you have to multiply your average daily balance by your daily periodic rate and by the number of days in your billing cycle.

The daily periodic rate is:


18% / 365 = 0.00049315


The interest charge is:


$530 x 0.00049315 x 30 = $7.84


Therefore, your interest charge for that month is $7.84.

By making purchases and payments at beneficial times during your billing cycle, you can use the average daily balance approach to lower your interest payments. 

For instance, if you pay off a balance earlier in the billing cycle, it will be lower for longer and the average daily amount will be lower. Similarly, if you make a purchase later in your billing cycle, you will raise your daily balance for fewer days and lessen the effect it has on your average daily balance.

The average daily balance method is one of several methods that credit card issuers can use to calculate interest charges. Other methods include:

• Previous balance method: Instead of using the balance due at the end of the most recent billing cycle, this method bases interest rates on the amount owed from the beginning.
• Adjusted balance method: According to this technique, interest is calculated on the balance due at the end of the previous billing month less any credits and payments made in the current billing period. The billing statement for the following month will include any new purchases.
  

Because it takes account of fluctuations in your balance over the course of your billing cycle, the average daily balance technique is typically regarded as being more equitable than these alternatives.